FRC - First Republic Bank: A Shrewd Move To Preserve Capital

2023-04-12 14:56:13 ET

Summary

• The management team at First Republic Bank announced that it had decided to suspend the distributions on their preferred stock.
• This move is a big, but unexpected, blow to holders of those units, and it makes a lot of sense for First Republic Bank to make it.
• It's telling that this was seemingly voluntary, but it does come with some risk to the business.
• Investors should view the common stock as being far more attractive than the preferred now.

May we be cursed to live in interesting times. This statement, often considered to be a Chinese curse, has always been appealing to me. It seems like, no matter what age somebody lives in, interesting events are taking place. One of the most interesting things right now is the continued uncertainty regarding the banking sector. One of the latest developments in this space involves a company called First Republic Bank ( FRC ). Starting in early March, shares of the company took a beating as concerns mounted about a potential run on the institution. So far, shares are currently down 91.7% from their 52-week high mark. Comparatively speaking, the preferred stock that the company has held up far better. Given that the company has seven different issues of preferred stock, it shouldn't be a surprise that there is some variation from one issue to another when it comes to overall downside. But as of this writing, units of the preferred stock are down between 73.9% and 76.6%.

Those who are bullish on the company may view this return disparity as an opportunity to generate attractive returns moving forward. In some respects, I can understand this sentiment. But given the most recent developments announced by management on April 6th, I would make the case that anybody who is looking to go long on the business would be wise to either invest in the common stock directly, or to consider an options contract if applicable. At this point, the preferred stock no longer makes sense, and investors should be cautious about picking it up.

Reasons to like preferred stock

To the best of my recollection, I have never purchased shares of preferred stock. For one reason or another, I've always been drawn more to the common stock of a business. This is not to say, however, that there aren’t multiple good reasons to consider preferred stock for your portfolio. For starters, in the event of a bankruptcy scenario, preferred units technically have seniority over the common. Though this is the case, I also should add that I have rarely seen preferred shareholders walking away with anything of substance from a bankruptcy scenario. This is because when a company does go under, it's often laden with debt and its assets are not valued highly enough in the restructuring or liquidation process to leave much leftover for shareholders of any kind.

Outside of the liquidation scenario, preferred stock can have many benefits. But it's important to keep in mind that preferred stock as a class is not a monolith. You can have preferred units of one type that have significantly different traits than preferred units of a different type. Instead of providing a comprehensive review of what scenarios you might encounter, I think it would be best to focus solely on the preferred stock that has been issued by First Republic Bank.

All seven series of the preferred stock that have been sold by First Republic Bank have a liquidation value of $25 (for 1/40 ^th of a preferred unit). They have, historically speaking, paid out distributions to investors. But those distributions vary based on which preferred units we are discussing. The lowest payout comes from the Series M preferred units, which carry a distribution rate of 4%. And the highest would be the Series I with its 5.50% distribution rate. All combined, the implied value of the preferred stock issued by First Republic Bank is $3.63 billion.

As is the case with any preferred stock, the holders of First Republic Bank’s units are entitled to a distribution before common shareholders get a penny. If the company gets sold off, the preferred holders get paid first as well, just like in the event of a liquidation or restructuring. In many cases, preferred units might be cumulative in nature. This means that even if distributions are halted, they build up and must be paid to common shareholders before common holders get anything. But sadly for investors in these units, the cumulative feature does not apply. That is why April 6th was such a dark day for investors in the preferred units. Even though the price of the preferred units did not fall drastically in response to the news, likely because it was anticipated well in advance, the management team at the bank decided to suspend payments on each of the series of preferred stock.

Why preferred units no longer make sense

What this means for investors is that, unlike in the case of cumulative preferred stock, any quarterly payout that otherwise would have happened will be lost forever. Had these been set up as cumulative units, the distributions would accrue and, if the company survives the current downturn, eventually be paid back in a lump sum once the enterprise resumes distributions. Interestingly, though perhaps unsurprisingly, the units that had the highest distribution rates fell slightly less than those that had lower distribution rates (with the exception of the Series N notes that were a clear outlier). After all, in the event that the preferred distributions ever get reinstated, you would expect the preferred stock that had the highest stated distribution rates to be more attractive than those with lower stated distribution rates.

This has created an interesting peculiarity though. The implied yield, assuming that First Republic Bank does eventually pay out its preferred distributions, varies materially from one series of the preferred stock to the next. The Series I units, for instance, have the highest forward yield, even though the risk profile from series to series should be virtually identical.

Strategically speaking, this maneuver by First Republic Bank was a wise one. Last year, the management team at the bank ended up paying out $158 million to preferred stockholders. That number this year should be around $161 million based on my own calculation. There are scenarios in which the company could be forced, from a regulatory perspective, to stop paying distributions. But in its press release on the matter, management called this decision a ‘measure of prudent oversight’. As I wrote in another article recently, the enterprise is slated to report financial results for the most recent quarter before too long. By then, we will know just how necessary this decision was. But paying out cash that it doesn't need to at this time would not be strategically wise.

There is a risk, however, in utilizing this approach. In looking at the terms of each series of preferred stock, I found a clause that stated that, while preferred units are not cumulative, the decision by management to forego payments on six separate occasions, whether that is consecutive or otherwise, would result in the holders of each series having the right to appoint two directors to the company's board. This means that this is not a long-term solution. Rather, it is merely a band-aid aimed at preserving capital.

Takeaway

Some investors may be wondering whether now might be the time to jump in and buy stock in the enterprise. I personally recognize this as a highly risky prospect. But I am considering a speculative strategy involving the purchase of call options on the business. I would see this as highly profitable if things go according to plan. For those who aren't interested and or not able to engage in options contracts, the decision is between the common units and the preferred. To be clear, the aforementioned advantages of the preferred stock still apply. But given that downside potential for both common and preferred is probably identical or close to it, I personally wouldn't use that in the decision-making process.

As I showed already, those who do decide to buy the preferred stock would probably be best off picking the higher-yielding series. But when it comes to overall upside, it's a guarantee that shares will not trade materially above the liquidation price of $25 per unit. Even with the cheapest units at this time, this would imply upside of 326.6%. But for common shareholders, the difference between the roughly $14.00 that units are trading for today and the more than $170 they traded at over the past year, is far greater. To me, this makes the common shares a vastly superior option for investors who are comfortable enough with the risk to put money into the company as it stands.

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