OZKAP - Bank OZK Preferred Stock: Still Time For The Train Of Lower Interest Rates

2023-11-28 22:06:00 ET

Summary

• Inflation has frozen month-to-month for the first time in two years, leading to a decrease in the 10-year treasury yield.
• The S&P 500 has rallied 10% in response to the decrease in interest rates, but Bank OZK's preferred stock has only gained 2%.
• Bank OZK's preferred stock offers a high dividend yield of 7.7% and has great upside potential, as the bank is well protected from financial sector headwinds.

The latest CPI report , which was issued two weeks ago, showed that inflation froze month-to-month for the first time in two years while the year-on-year inflation fell from 3.7% in September to 3.2% in October. As the decrease in inflation was steeper than expected, the 10-year treasury yield has plunged from a 16-year high of 5.00% in late October to 4.38% now.

As high interest rates greatly reduce the present value of future earnings, they tend to compress the valuation of stocks. Therefore, it is only natural that the S&P 500 has rallied 10% during the last month amid the plunge of the 10-year treasury yield. This rally may have led some investors to think that they have missed the train of lower interest rates, i.e., the rally of the stock market thanks to expectations for lower interest rates in the near future.

However, the preferred stock of Bank OZK ( OZKAP ) has gained only 2% during the last month and hence it still has great upside potential. I recommended buying this stock about six months ago for its exceptionally high dividend yield and the robust business model of the bank, which results from its exemplary management. Since then, the stock has offered a total return of 7% but it remains attractive. In addition, the recent presentation of the third-quarter results of Bank OZK confirmed that the bank is well protected from the business headwinds facing the financial sector, such as the decrease in the total deposits of the sector and a shrinking net interest margin amid rising costs of deposits.

Periods of high interest rates are ideal for locking in exceptionally high yields. Whenever the market begins to expect lower interest rates, it usually rewards stocks with richer valuation levels, which results in lower yields. This is exactly what has happened this month, as the recent shift of expectations about future interest rates has triggered a rally in the S&P 500. However, income-oriented investors have not missed the train of lower interest rates. They can lock in the 7.7% dividend yield of the preferred stock of Bank OZK and wait patiently for the great upside potential of the stock whenever the Fed begins reducing interest rates.

Overview of the preferred stock of Bank OZK

The preferred stock of Bank OZK is perpetual and non-cumulative, i.e., any missed dividends are forgone forever. However, investors should not worry about the safety of the preferred dividend. The bank cannot reduce its preferred dividend unless it first eliminates its common dividend. Bank OZK has grown its common dividend for 53 consecutive quarters and its dividend has a wide margin of safety for several reasons (more on this below). Therefore, the bank is not likely to cut its common dividend, let alone eliminate it.

The reason behind the exceptionally high dividend yield of 7.7% of the preferred stock of Bank OZK is the 39% discount at which the stock is trading compared to its par value of $25. The deep discount has resulted primarily from the surge of interest rates to a 16-year high, but also from the negative market sentiment on regional banks. The negative market sentiment resulted from the bankruptcy of Silicon Valley Bank, Credit Suisse, and First Republic early this year. Their bankruptcy was caused by two factors: devastating losses of the bond portfolio of these banks due to the surge of interest rates and a resultant steep decrease in deposits due to a loss of faith in the banks from consumers.

However, Bank OZK is well protected from these risk factors. First of all, the investment portfolio of the bank does not include any long-term bonds. It only includes short-term bonds, which will be held to maturity. As a result, in the third quarter, the bank posted a decrease of just $0.38 billion in the mark-to-market value of its $3.15 billion investment portfolio over the prior year’s quarter.

Source: Investor Presentation

This loss is temporary, as the bank will hold its bonds until they mature. Even better, the temporary loss is just 10.6% of the value of the investment portfolio and much less than the all-time high earnings of $679 million of the bank in the last 12 months. Therefore, the company is hardly affected by the impact of 16-year high interest rates on the mark-to-market value of its investment portfolio, in contrast to the aforementioned banks, which went out of business due to this impact.

Moreover, Bank OZK has proved immune to the outflow of deposits that the above banks and many other financial institutions have incurred this year due to the tightening policy of the Fed. Total US deposits have decreased from $18.0 trillion at the end of 2022 to $17.3 billion in October. However, Bank OZK has steadily grown its deposit base for four consecutive quarters, from $20.4 billion in September 2022 to $25.6 billion in September 2023, for a total increase of 25%.

Source: Investor Presentation

The 25% increase in the deposits of OZK Bank amid financial turmoil and a tightening policy of the central bank is a testament to the strength of the business model of the bank and its great reputation. Most of the deposits of Bank OZK are generated through its network of 229 branches in 5 states. Thanks to their retail nature, 81% of these deposits are insured.

A major reason behind the trust of consumers is the superior asset quality of Bank OZK. To be sure, the company has posted a lower net charge-off ratio than the average ratio of the entire financial sector every single year since 1997.

Source: Investor Presentation

Thanks to its disciplined management, Bank OZK has exhibited impressive consistency, not only in its net charge-off ratio but also in its growth of earnings and dividends. The bank has grown its earnings per share in 7 of the last 9 years, at a 15.3% average annual rate. It has also raised its common dividend for 27 consecutive years and hence it is a Dividend Aristocrat. While many banks incurred excessive losses and cut their dividends during the Great Recession, Bank OZK continued raising its dividend. It is also impressive that the bank has raised its common dividend for 53 consecutive quarters.

In spite of having raised its dividend for 27 consecutive years, Bank OZK still has an exceptionally low payout ratio of 25% . In addition, the bank is expected by analysts to grow its earnings per share by 29% this year, by 2.5% next year and by another 5% in 2025. Given also the resilient business model of Bank OZK, it is safe to expect the bank to keep raising its common dividend for many more years. Therefore, the common dividend is extremely unlikely to be eliminated and hence the preferred dividend of Bank OZK is entirely safe.

Upside potential

The preferred stock of Bank OZK is trading at a 39% discount to its par value of $25, at $15.15. The deep discount has resulted from the surge of interest rates to a 16-year high, as high interest rates enable investors to identify attractive yields elsewhere and hence they exert pressure on the prices of preferred stocks.

However, it is unrealistic to expect interest rates to remain around their 16-year highs forever. As soon as inflation reverts to the target zone of 2.0%-2.5% of the Fed, the central bank is likely to begin reducing interest rates. When that happens, the preferred stock of Bank OZK will begin to retrieve its losses. If interest rates revert to the depressed levels they were during 2008-2021, the preferred stock of Bank OZK will probably revert to its per value of $25. Therefore, the stock has 65% upside potential. If interest rates do not revert to their depressed levels but stabilize below their current levels, the preferred stock of Bank OZK will have less (than 65%) upside potential but still material upside potential.

Risk

The business model of Bank OZK has proved resilient to all kinds of downturns, such as the Great Recession and the coronavirus crisis. In fact, a mild recession will probably benefit the preferred stock of Bank OZK, as it will lead the Fed to lower interest rates and thus the preferred stock will probably appreciate.

The only material risk for the preferred stock of Bank OZK is the unfavorable scenario of sticky inflation for years. In such a case, interest rates are likely to remain elevated and hence the preferred stock of Bank OZK will remain under pressure. However, thanks to the aggressive policy of the Fed, inflation has decreased at a fast pace, from a peak of 9.2% in the summer of last year to 3.2% now. It is thus reasonable to expect inflation to revert to its long-term range of 2.0%-2.5% at some point in 2024 or 2025, particularly given the determination of the Fed.

Even in the unlikely scenario of persistent inflation for years, the preferred shareholders of Bank OZK will continue receiving the 7.7% dividend, which has a wide margin of safety. Of course, the 7.7% yield will be less attractive in an environment of high interest rates but still, it will render the worst-case scenario tolerable for the preferred shareholders.

The bottom line

The steep rally of the S&P 500 after the latest CPI report has caught many investors off-guard and hence these investors are afraid that they may have missed the train of lower interest rates. The preferred stock of Bank OZK is a great investment option for these investors, as it enables them to lock in a 7.7% dividend for the long run while it also offers them significant upside potential.

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