NTB - Bank of N.T. Butterfield & Son Closed 2022 Strong And Remains Undervalued

Summary

• Bank of N.T. Butterfield closed 2022 on a high note with a fourth quarter report that had quality beats across the income statement.
• Loan growth potential is more modest than for many banks, but Butterfield is still leveraged to higher rates in 2023 and should manage double-digit pre-provision profit growth.
• Long-term core earnings growth in the low-to-mid single-digits is enough to drive a mid-$40s fair value, making this an overlooked name well worth further due diligence.

Bermuda-based Bank of N.T. Butterfield & Son ( NTB ) is never going to be your typical bank, given that it operates in concentrated markets like Bermuda, the Cayman Islands, and the Channel Islands where the economic drivers and competitive situations are different than for your typical U.S. regional or community bank. Even so, the basics of banking don’t change, and Butterfield has shown that it can manage underwriting risk and operate efficiently through multiple cycles.

Butterfield’s fourth quarter earnings were good, while the outlook for loan growth would seem to be on the lower end of the mid-single-digit range, I expect residual rate tailwinds to drive low double-digit pre-provision profit growth in 2023 before a more significant slowdown in FY’24. I also expect to see meaningful capital returns, as the bank sports an exceptionally high CET1 ratio and just authorized a new 3 million share buyback.

Up more than 10% since my last write-up , with a big post-earnings move, I still think Butterfield is undervalued. This will never be the most exciting bank to own, but I don’t know that you want excitement from a bank and I think steady execution can drive respectable long-term returns without a lot of idiosyncratic volatility.

Good Results Pretty Much Down The Line

There were a couple of curiosities in Butterfield’s fourth quarter report, but this was an all-around solid set of results and the bank is well-placed going into a year where rate tailwinds should help drive net interest income even as deposit costs continue to climb.

Revenue rose more than 17% year over year and 6% quarter over quarter, beating expectations by about $0.125/share. Net interest income grew around 4% qoq, which wasn’t all that impressive next to U.S. regional banks (where growth was closer to 6%), but it was still good for a $0.04/share-plus beat. Net interest margin rose 79bp yoy and 20bp qoq to 2.79%, while earning assets fell almost 4% qoq.

Fee-based income rose 4% yoy and 10% qoq, beating by about $0.08/share.

Operating expenses rose 1% yoy and a little more than 3% qoq, and while that exceeded sell-side expectations by about $0.035/share, Butterfield beat by about 240bp on efficiency ratio (meaning the incremental revenue more than covered the incremental cost).

Pre-provision profits rose about 10% qoq, which was better than average and over $0.09/share ahead of sell-side expectations. Slightly lower provisioning and a lower tax rate also helped, adding another $0.02/share or so and making for an $0.11/share core earnings beat.

Good Deposit Performance, But Limited Loan Growth Is A Modest Concern

Loans rose about 2% sequentially in the quarter, which was a little light compared to U.S. regional banks, but not significantly lower. Average loan balances declined about 2%, with commercial about 3% and consumer (mostly mortgages) down 1%. Loan yields rose 161bp yoy and 74bp qoq to 5.79%, driving a healthy 42% loan beta, and Butterfield continues to benefit from a comparatively less competitive loan market in its main operating areas.

Loan originations were down about 15% qoq, though, and I’m only expecting around 4% loan growth in FY’23 and FY’24. While Bermuda and Cayman Island-based financial institutions are doing well, Butterfield doesn’t do a lot of business directly with them, and higher rates are having an impact on sectors like residential real estate. Tourism is another major driver, though, and that could drive a little more growth and loan demand in the coming years as travel & tourism patterns continue to normalize.

One of the curiosities of Butterfield’s quarter was that while the prior quarter showed unusual contraction in deposits compared to U.S. regional banks, this quarter went the other way. Deposits actually grew more than 4% sequentially, with non-interest-bearing deposits up close to 3%. Even allowing for seasonality, that’s a good performance and it has had a beneficial impact on funding costs.

Deposit costs rose 68bp yoy and 44bp qoq to 0.78%, which is still comparatively low, with interest-bearing costs up 88bp yoy and 58bp qoq to 1.03%. Butterfield’s cumulative deposit beta of 18% isn’t bad; it’s by no means sector-leading, but for the size of the bank, it’s definitely no worse than average.

I do expect deposit costs to rise from here, and I think Butterfield will likely see its NIM peak in the first quarter of 2023. The good news, though, is that there are still attractively-priced loans coming onto the balance sheet and I don’t expect a particularly sharp descent from a peak NIM around 2.8% over the next two years – I expect 2024 NIM will still be well ahead of 2021’s level and comfortably above 2020’s as well.

Credit costs will rise from here, but non-performing loans have been pretty steady as a percentage of loans, while charge-offs have been gradually accelerating – from 0.04% a year ago to 0.07% in the second quarter, 0.08% in the third quarter, and 0.11% in the fourth quarter of this year. At this point, I do think the loan loss reserve is light at 0.5%, but Butterfield’s long-term credit track record doesn’t argue that the bank needs to dramatically boost reserves at this point.

The Outlook

I do expect growth in the business to slow significantly in 2024, but 2023 should be a strong year as the bank rides the tailwinds of higher rates. I don’t expect dramatic improvements in operating efficiency (this is already an efficiently-run bank), but management is supporting some growth projects, like a recently-launched mass affluent business in the Channel Islands. I do also expect the bank to be open to M&A if they can find attractively-priced trust, wealth management, or treasury businesses within their targeted footprint.

I expect low double-digit pre-provision profit growth in FY’23 and single-digit growth in FY’24, and my expectations for core earnings are broadly similar. Longer term, I expect low-to-mid single-digit core earnings growth. Growing the fee-generating businesses would be one attractive option for boosting the growth rate, as I do think the nature of the company’s operating footprint does cap loan growth opportunities.

Between discounted core earnings, ROTCE-driven P/TBV, and P/E, I believe Butterfield shares remain undervalued. Discounted core earnings give me a mid-$40s fair value, and I get basically similar results with the other two methodologies. For the P/E-based approach, I’m using a 9x multiple on my ’23 EPS estimate of $5 (up from $4.76 before). I do also expect meaningful capital returns to shareholders via buybacks.

The Bottom Line

Butterfield will never be flashy and it won’t be a growth leader, but it doesn’t need to be. This stock can work with management following their plan and continuing to look for attractive incremental opportunities. Trading more than 15% below my estimate of fair value, I think these shares remain worth consideration.

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