OZKAP - Bank OZK Preferred Stock: Attractive Dividend And Upside Potential

2023-09-14 10:53:34 ET

Summary

• Bank OZK's preferred stock has underperformed due to high interest rates and inflation, but this is expected to be temporary.
• The preferred stock is offering a secure 7.7% dividend and up to 65% upside potential.
• Bank OZK has exhibited strong business performance, with market-leading net interest margin and earnings growth, making it a resilient and well-managed bank.

Almost four months ago, I recommended buying the preferred stock of Bank OZK ( OZKAP ), which is perpetual, non-cumulative and has a fixed dividend, for its exceptional yield, its great upside potential and the rock-solid business model of the bank. Since my article, the preferred stock has offered a total return of 4.5%, which is less than the 8.0% return of the S&P 500. The underperformance has resulted from the persistence of inflation, which has led the Fed to remain hawkish for longer than initially anticipated. However, this is likely to prove just a temporary headwind.

In addition, Bank OZK has exhibited remarkably strong business performance this year, better than the vast majority of banks. Moreover, the stock is offering a secure dividend yield of 7.7% and up to 65% upside potential if interest rates deflate from their current 15-year highs. Furthermore, the latest earnings report of Bank OZK confirmed the resilience of the bank to the ongoing financial turmoil. Therefore, investors should wait patiently for the preferred stock of Bank OZK to highly reward them in the upcoming years.

The reason behind the recent underperformance

The preferred stock of Bank OZK is currently trading at $15.12, which corresponds to a 40% discount to its par value of $25. The primary reason behind the deep discount is the surge of interest rates to a 15-year high due to the efforts of the Fed to restore inflation to its long-term target zone of 2.0%-2.5%.

The preferred stock of Bank OZK is highly sensitive to interest rates due to its fixed dividend. High interest rates enable investors to identify attractive yields in many bonds and stocks and hence they render many preferred stocks less attractive. Consequently, the prices of preferred stocks are compressed so that these stocks offer high yields. This is exactly what has happened to the preferred stock of Bank OZK.

Until a few months ago, the market was expecting the unprecedented rate of interest rate hikes implemented by the Fed to cool the economy enough and bring inflation down to 2.0%-2.5% at the end of this year. Analysts were expecting the Fed to stop raising interest rates in the summer and even begin reducing interest rates at the end of this year. Unfortunately, inflation has proved somewhat stickier than expected. As a result, the Fed is likely to raise interest rates at least once more this year. In addition, the central bank is not expected to begin reducing interest rates later this year. The extension of the period of 15-year high interest rates has weighed on the price of all the preferred stocks, including the preferred stock of Bank OZK.

However, investors should realize that this setback is only temporary. The Fed has clearly stated that it will exhaust its means to restore inflation to its target range. While this process may take longer than initially expected, one should rest assured that the Fed will eventually accomplish its goal. To be sure, the central bank has managed to reduce inflation from a 40-year high of 9.2% in June 2022 to 3.2% now. Whenever the Fed restores inflation to 2.0%-2.5% and feels secure that inflation has come under control, it will begin lowering interest rates.

Lower interest rates will provide a strong tailwind to the preferred stock of Bank OZK. Whenever interest rates revert to their level in early 2022, the preferred stock of Bank OZK is likely to revert towards $25, its level in early 2022. Of course, if interest rates do not revert to their level in early 2022, the rally of the preferred stock of Bank OZK will be less than 65% (=25/15.12) but it will still be highly rewarding.

Why the preferred dividend of Bank OZK remains safe

As mentioned above, the primary factor behind the deep discount of the preferred stock of Bank OZK is the adverse environment of 15-year high interest rates. The other reason behind the discount is the negative market sentiment over regional banks after the collapse of Silicon Valley Bank, Credit Suisse and First Republic. The financial turmoil resulted in an extremely negative market sentiment over all regional banks, regardless of their special characteristics. This indiscriminate sell-off has created a great investing opportunity, as Bank OZK is an exceptionally well managed bank, which can easily endure the ongoing turmoil. The resilience of Bank OZK to the ongoing financial turmoil was confirmed in the latest earnings report of the company.

Bank OZK is a regional bank with 230 retail branches in Arkansas, Georgia, Florida, North Carolina and Texas.

Bank OZK has proved one of the best performing banks in several metrics this year. To be sure, in the first half of this year, it posted net interest margin of 5.4%, which was much higher than the 2.5%-3.5% net interest margin of the vast majority of regional banks. To provide a perspective, Cullen/Frost Bankers ( CFR ), Community Trust Bancorp ( CTBI ) and Huntington Bancshares ( HBAN ) posted net interest margin of 3.45% , 3.35% and 3.11% , respectively, in the second quarter. The net interest margin of most banks seems to have peaked in the last two quarters, as their cost of deposits has increased amid intense competition among banks for deposits. The cost of deposits has increased for Bank OZK as well but this bank has greatly benefited from rising interest rates, as the borrowing costs of its borrowers increase in tandem with interest rates.

The merits of the rock-solid business model of Bank OZK were evident in its latest earnings report. In the second quarter, the company grew its net interest income 3% over the prior year’s quarter, in contrast to most banks (including the aforementioned regional banks), which incurred a decrease in net interest income due to higher costs of deposits. In addition, Bank OZK grew its total loans and deposits by 7.0% and 7.6%, respectively. As a result, it grew its earnings per share 34%, from $1.10 to an all-time high of $1.47, and exceeded the analysts’ consensus by $0.04. Notably, the bank has exceeded the analysts’ consensus in 12 of the last 13 quarters, thus confirming its sustained business momentum. The above performance combined with the 7.6% increase in deposits is a testament to the resilience of this high-quality bank to the financial turmoil that has affected other regional banks.

Thanks to its robust business model, Bank OZK has proved resilient to all kinds of downturns, including the Great Recession, the pandemic and the recent financial turmoil. The bank has always maintained a defensive loan structure in order to secure itself against downturns in its business.

As shown above, Bank OZK has a loan-to-value ratio of 43%. In other words, even if a borrower defaults on his loan, the value of the property compensates the bank adequately and thus it mitigates the risk of the bank. It is also important to note that Bank OZK has posted an eye-opening average annual net charge-off ratio of only 0.08% over the last 20 years. This is a testament to the quality of the loan portfolio of the bank.

The exemplary management of Bank OZK is clearly reflected in the exceptional growth record of the bank and its unparalleled (in the financial sector) dividend growth record. In the Great Recession, when most banks incurred excessive losses and cut their dividends drastically, Bank OZK continued growing its earnings and its dividend. The bank has raised its common dividend for 27 consecutive years. Notably, it has raised its dividend in every single quarter over the last 13 years.

In reference to the position of the preferred stock of Bank OZK in the capital stack, the total preferred equity is only $339 million, while Bank OZK has long-term debt of only $352 million and a market capitalization of $4.4 billion. As the annual earnings of the company are $621 million , the annual preferred dividend of $16 million has an extremely wide margin of safety.

It is also remarkable that Bank OZK has spent $160 million on share repurchases during the first half of this year, as it has taken advantage of the decrease in its stock price due to the collapse of some regional banks. It has also kept raising its common dividend in every quarter. The most recent dividend hike, which was announced in July, marked a 12.5% increase over the prior year’s quarter. As the payout ratio is only 26% , the bank has plenty of room to keep raising its dividend for years.

The ample share repurchases and the continuing dividend hikes are testaments to the safety of the common dividend. A Company that struggles to fund its dividend does not spend substantial amounts on share repurchases nor does it raise its dividend quarter after quarter. To cut a long story short, the common dividend of Bank OZK has a wide margin of safety. Therefore, the 7.7% preferred dividend of the stock is safe as well. As a reminder, a company cannot cut its preferred dividend unless it first eliminates its common dividend. As mentioned above, the common dividend of Bank OZK is likely to keep rising for the foreseeable future and hence it is not likely to be eliminated. Overall, the preferred stock of Bank OZK is offering a 7.7% dividend, which is as safe as it gets.

Risk

The only material risk factor for the preferred stock of Bank OZK is the unfavorable scenario of persistently high inflation for years. In such a case, interest rates are likely to remain at excessive levels for an extended period and hence the preferred stock of Bank OZK will probably remain under pressure for much longer than currently expected.

However, the Fed has already managed to cool inflation from 9.2% in June 2022 to 3.2% now and is determined to restore inflation to 2.0%-2.5% by any means. As a result, the central bank is likely to achieve its goal at some point in late 2023 or 2024. Overall, the preferred stock of Bank OZK will be negatively affected if high inflation persists for years but such an adverse scenario has low odds of materializing.

Final thoughts

The preferred stock of Bank OZK is offering an attractive dividend yield of 7.7% and upside potential of up to 65%, if interest rates revert towards their nearly all-time low levels in early 2022. No-one can predict when interest rates will revert to those levels but a potential recession in the future will probably lead interest rates to those levels. Even if interest rates will not revert to their levels in early 2022, they will certainly moderate off their current 15-year highs. When that happens, the preferred stock of Bank OZK could rally from its current depressed price. As no-one can predict the timing of the reversal of the interest rate policy of the Fed, investors should be patient. Nevertheless, the secure 7.7% dividend of the preferred stock of Bank OZK makes it easy to wait for the above investment thesis to play out.

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