OZKAP - Bank OZK: A Hilltop View In Financials

2023-04-13 04:58:32 ET

Summary

• Bank OZK, like most financial institutions, has been buffeted by macro headwinds.
• Fact: Failures are cropping up among regional banks.
• OZK is among the stronger regional banks at an attractive price point and with an appealing dividend and earnings history.
• I rate OZK a 'Buy' for medium- and long-term investors.

Introduction

Bank OZK ( OZK ) is a strong regional bank based in Arkansas. OZK is a solid company with leadership that has pursued consistent strategies and adjusted well to internal and external issues and crises. The executive team appears well-positioned to continue that record.

Valid concerns for investors about OZK relate mostly to current macro issues around the banking sector and the real estate markets. This Seeking Alpha article describes actions the large banks are currently taking to address concerns about the health of the overall system after the collapse of Silicon Valley Bank and the severe tribulations of additional banks such as FRC (First Republic Bank). Large institutions' decision to bolster cash reserves by substantial amounts reflects both an objective threat and a desire to reassure both investors that the banking sector is sound. If the financial system is threatened systemically, then not a single bank stock will be easy to hold.

The macro real estate market questions might well impact a number of regional banks that focus loans in this area. That includes OZK, which does play heavily in that space.

Without doubt, risks to both financial and real estate environments are intertwined. In the short term, both will raise doubts about financial stocks.

When stretching the perceptive horizon, individual bank corporations will succeed or fail based on execution of sound strategies. Against this measuring stick, OZK is a solid Buy at current share price levels.

A Note on Financial Sector Investing

Investing in banks of all sizes and scopes is not a very scientific process. Of course, the same might be said for investing in general. With financial institutions such as banks and insurance companies, there are many variables relating specifically to losses and loss reporting.

The legendary W arren Buffett addressed this in a response to a question from the well-known money manager Bill Ackman at a Berkshire-Hathaway meeting. Ackman wanted to know why there have been so many false and misleading statements from financial institutions and why the government and various rating agencies do not respond coherently to this issue.

Buffett, in his customary calm and deliberate manner, responded.

Financial companies are more difficult to analyze than many companies…take the insurance companies as an example. The biggest single element that is difficult to evaluate is…the loss and loss adjustment expense reserve, and that has a huge impact on reported earnings."

Warren points out that the loss numbers can be huge and that accounting errors can introduce massive short-term distortions. Logically, these will hit quarterly reports and expectations head-on.

On banks specifically, Buffett cited the difficulty of computing many thousands of transactions that involve multiple variables:

In a bank…it's basically whether the loans are any good…then you throw in derivatives on top of it…

It's very very tough to know precisely what's going on in a financial institution...it's just a more dangerous field to analyze. It doesn't mean you can't make money in it, we've made a lot of money in it. "

Positives and Perils of Regional Banks

Regional banks differ from the giant corporations such as JP Morgan (JPM), Citibank (C) or Bank of America (BAC). Their resources are more limited. They depend heavily on individual branch customer deposits to fuel their lending activity. Their customer bases may be more loyal, but the regionals are far more vulnerable to the impacts of accounting errors (or fraud) that Warren Buffett addressed.

Regional banks can also be more nimble, have smaller C-suites and greater flexibility in setting strategic policies. In the case of OZK with its stable leadership that has a long working partnership, definite advantages derive from being a smaller institution.

What about investing in the sector in general in the aftermath of SVB's collapse and the deep problems of some other regionals like FRC? CNBC Fast Money host Melissa Lee addr essed these questions with a March guest, Christopher Marinac of Janney's:

Melissa Lee began the discussion by asking Mr. Marinac if now is a time to hunt for bargains in regional bank stocks. Marinac advocates investing in the space:

…There's a lot of companies and management teams that you can acquire at a big discount…we advocate taking a flush of Tangible Book Value including all the health and maturities security losses that are unrealized…the markets are in the process of doing that…there are a lot of great buys."

Note: Tangible book value , [TBV], is determined on a per-share basis by measuring equity without the inclusion of any intangible assets …[these] lack physical substance, making their valuation more difficult. Analysts make this empirical by dividing shares into the total TBV to create a formula. Keep in mind that even tangible assets can be miscalculated in accounting statements at times.

Lee asks Marinac to identify specific items that help investors decide which regional banks will be survivors in the current atmosphere:

So you start with tangible book value, and then you have to make adjustments for the unrealized losses that are in securities portfolios, so the…health and securities losses, which you can take out…so when you do that a lot of names are still inexpensive here…"

Melissa Lee presses her guest on how regionals will achieve near-term profitability given potential operating losses.

We think the access to capital will be constrained. There won't be capital raises for a while…I think reserve building will continue, but the basic spread business is still intact."

I place OZK squarely in the survivor category among regional banks hit by the macro realities.

OZK: The Business Case

OZK has a record of focusing on real estate lending of different types targeted to different audiences. It leverages its collected branch deposits as a source of funds to provide various loans. The bank has consistently diversified loan types while increasing the quantity of loans available within its portfolio.

The company has a good record of transparency despite some past difficulties in commercia l real estate loans during a period of expansion to the New York market. The decision to branch out from the traditional Southern regional focus produced heavy losses and some doubts about strategic decision-making.

Despite this and a few additional controversies, OZK has demonstrated a basically methodical approach to expanding its loan operations.

The latest OZK SEC 10-K filing starts with a summary of the bank's business operations, followed by a description of OZK business strategy, which I quote in condensed form:

We believe that stable long-term growth and profitability are the result of developing comprehensive, strong banking relationships with our customers by offering a wide range of products and services and delivering excellent customer service while maintaining disciplined underwriting standards. We are focused on originating high-quality loans and growing a stable deposit base…We are focused on growing our non-purchased loan portfolio while remaining committed to our conservative credit culture…We expect to continue to pursue meaningful non-purchased loan growth, including growth within RESG, while diversifying our growth to achieve more balance between CRE lending and other types of loan originations…Our indirect lending business is a national lending platform that primarily focuses on recreational vehicle ("RV") and marine lending helps us achieve diversification within our loan portfolio. We expect that production from our other lending teams such as our Community Banking division (which includes consumer finance, small business, government guaranteed, business aviation, affordable housing, middle market CRE homebuilder finance, equipment finance and capital solutions groups)…will continue to further contribute to diversification in our earning assets over time."

There are no radical changes in strategy but there is a determination to create and build new business lines and expand business consistently.

Real Estate Loan Focus

The same 10-K breaks out the OZK real estate loan component areas:

• Real estate loans are a major part of the loan portfolio. They include loans secured by residential 1-4 family, non-farm/non-residential, agricultural, construction/land development, multifamily residential properties and other land loans. The family loans include equity lines of credit.
• Non-farm/non-residential loans feature those secured by real estate mortgages on owner-occupied commercial buildings of various types and extend to leased commercial, retail and office buildings, various medical facilities, hotels and motels, mixed use properties and other business and industrial properties.
• Agricultural real estate loans include loans secured by farmland and related improvements, including some loans guaranteed by the Farm Service Agency ("FSA") and the Small Business Administration ("SBA").
• Real estate construction/land development loans include those secured by vacant land and loans to finance land acquisition, development or construction of industrial, commercial, residential or farm buildings.

OZK's real estate loan products are generally amortized over five to thirty years, payable in periodic installments of principal and interest, and payable in full (unless renewed) at a balloon maturity within seven years. A major portion of loans are structured as term loans with adjustable interest rates (daily, monthly, semi-annually, annually, etc.). Many adjustable rate loans have established "floor" interest rates.

Indirect Loans

OZK's portfolio of indirect loans includes loans to individuals primarily for the purchase of RVs and marine vessels, generated largely through relationships with dealers and correspondent lenders. These loans are generally collateralized by the purchased asset and underwritten based on borrower credit score, documented debt service coverage, previous asset ownership, experience and borrower liquidity.

Commercial and Industrial Loans

The OZK commercial and industrial loan portfolio consists of loans for commercial, industrial and professional purposes. These loans fund working capital requirements…and other purposes.

Among the commercial and industrial loans are subscription credit facilities and asset-backed facilities, business aviation financing, and our equipment finance, lender finance and structured finance solutions.

OZK offers a variety of commercial and industrial loan and financing arrangements, including term loans, balloon loans, lines of credit, and lease structures. Certain loans are guaranteed by the Small Business Administration (SBA), and are intended for businesses with the collateral supporting a particular loan determining its structure.

Consumer and Individual Business Loans

The OZK portfolio of consumer and business purpose, collateralized loans to individuals covers automobiles, equipment, ATVs, mobile homes and additional items for consumer or business purpose needs.

Additional loan types and structures are government guaranteed loans for credit facilities secured by various forms of real estate, equipment and other assets, small business loans linked to the purchase or refinance of real estate, equipment and lines of credit, and mortgage lending that includes long-term fixed rate loans.

OZK is also building a secondary market mortgage team since mid-2022 , and plans to expand this group to cover many of its branches no later than 2024.

The diversity of loan types - including short-duration - and the fairly wide target audiences add to the OZK strategic configuration. Proven strategic competence over a long time scale is another telling OZK attribute.

Financial Metrics

OZK financial measurements present a picture of excellent valuation and profitability and intelligent management producing good income and cash flow results.

I use the Seeking Alpha charts to review revenue, earnings per share, annual income and cash flow statements as well as for dividend/earning yield statistics.

Revenue performance for the four-year period beginning in late 2018 is uneven, but the overall trend is solidly up. The projections for full year 2023 and 2024 are also positive, though 2024 shows little expected growth over '23. I think it is easier to project 2023 than next year's, and here I will also defer to Warren Buffett's statements to Bill Ackman about the difficulties of predicting financial results in general.

The EPS trends are very consistent and clean and encouraging.

Annual income metrics are fine overall, particularly for income and net income. Those are pleasing numbers for investors to consider.

You can see a large jump in net income in 2021, with similar levels for 2022. However, net change in cash is negative, owing substantially to OZK investing activities and specific miscellaneous items.

Dividend/Earnings Yields

This page provides a comprehensive look at various dividend, cost, earnings, operating earnings and free cash flow yields. It's a positive look.

Stock Price, Book Value per Share & Price to Book Ratios

Here is a view of three perspectives on OZK share price performance and how that price relates to book value and book ratio.

Note the gradual, consistent increase in book value per share.

Guru Focus: Financial Strength/Safety...

This is another perspective that includes oft-ignored financial safety scores such as the Piotroski F-Score and the Beneish M-Score within the Financial Strength quadrant. The latter is mildly concerning.

Note: As this Investopedia article explains, a Beneish M-Score is derived from a mathematical model employing financial ratios and eight variables to identify whether a company has manipulated its earnings.

OZK Risks

I look at OZK risks in the context of a medium or long-term investment. The macro factors, which I have discussed, are very likely short-term in impact. If they stretch out further, the effects will be widespread across the market and take down legions of companies - and stockholders.

Risks that apply specifically to OZK may include:

• A failure in an aspect of strategy or execution. This would come likely in the assignment or execution of some large-scale loans. OZK has experienced some failures in commercial real estate operations in New York in the past, so this may be a concern. Risk: Low-to-moderate. Evidence shows OZK has learned from these setbacks.
• Too-ambitious expansion and potentially related execution issues. The end of year 10K filing shows a number of expansion programs under way. While none of these appear at face value to require huge capital expenditures, mediocre performance in a few of these programs will hurt. Risk: Low. Most of the new programs do not change core primary OZK strategies.
• A leadership change. CEO Gleason is nearly 70 years of age and may be approaching retirement. George Gleason is clearly a strong leader with a clear footprint within OZK. Risk: Moderate. Mr. Gleason seems to committed to the task and surrounded by competent top-level associates. It is fair to assume that OZK has good ideas about a succession plan.

Summary

I like OZK as an investment for a variety of reasons. Leadership is more than competent. OZK's executive team appears very methodical, experienced and prepared to weather all sorts of market and economic climates.

OZK's strategies appear sound. Performance metrics indicate a steady course through time and despite internal and external challenges. The metrics fit the story - unglamorous and an excellent long-term investing choice.

Looking out a year, I think $45 is attainable. No one should expect rocketing results from a regional bank stock, but OZK's make-up and dividend history are appealing for the patient. Combined with a larger financial name, OZK makes a fine portfolio diversification option.

Best of luck.

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