FRC - First Republic: Decent Q1 Earnings But Rising Funding Costs Pose Headwind

2023-04-25 00:06:39 ET

Summary

• First Republic Bank reported mixed Q1'23 results, with numbers beating analyst estimates, but revenues fell 16%.
• FRC didn't provide any guidance, and the collapse in deposits leaves the regional bank in a dire financial position going forward without access to cheap funding sources.
• Total deposits were down over $100 billion from Q4 levels when excluding the $30 billion deposits of large U.S. banks, suggesting the bank fails to hit 2023 financial targets.
• The bank stock won't rally until First Republic solves the business model issue.

While First Republic Bank ( FRC ) reported headline quarterly numbers better than the market feared, the regional bank reported some metrics suggesting a difficult future ahead. The bank will remain in a zombie state until cheap funding solutions are found. My investment thesis remains Neutral on the stock until the deposit situation is resolved.

Decent Quarter From First Republic Bank

Considering all of the drama and fears around whether First Republic could remain independent, the bank had a solid Q1'23 as follows:

First Republic reported revenues dipped 16% to $1.2 billion and the GAAP EPS plunged to $1.23, though the number easily beat analyst estimates. The problem with these short-term estimates is that the timing of the disruptions at the bank are difficult to analyze with the impact to Q1 only the last 3 weeks.

The bank has already seen the net interest margin plunge to 1.77%, down 68 bps from the prior quarter. The NIM was even boosted 11 bps by early CD withdrawal penalties of customers wanting out of the bank at all costs.

At the end of 2022, the regional bank had a deposit cost of only 163 bps leading to a NIM of 2.45% in Q4'22. The bank only had an average loan rate in the 3.5% range leading to the massive issue ahead.

The company continues to face a massive hole in the balance sheet with deposits down 41% from December to only $104.5 billion. The amount even includes the $30 billion in short-term deposits from large U.S. banks leaving the customer deposits down $101.9 billion from the end of 2022 levels at $176.4 billion.

The bank reported the total deposits somewhat stabilized through April 21 with a balance of $102.7 billion. Deposit levels only dipped $1.8 billion through the first 3 weeks of April based solely on tax payments.

First Republic ended the quarter with uninsured deposits of only $19.8 billion limiting expectations for future deposit outflows.

The problem here is that the regional bank saw average rates on loans budge up to only 3.7% while average deposit costs increased to 2.1%. The bank was paying over 4.3% on borrowings during the quarter and the amount surged from the minimal balance at the end of 2022.

First Republic will need to figure out a way to find cheap funding with deposits disappearing. The company had increased borrowings to $106.7 billion by the end of Q1 from minimal levels of only $15.3 billion as of the end of December. The April 21 borrowings level was down to $104.0 billion, but the amount still leads to over $1 billion in quarterly interest expenses from borrowings when the bank only paid $419 million during Q1'23 and minimal amounts back in 2022.

Zombie Business

The bank doesn't face any issues with loan quality with nonperforming assets at a minimal 6 basis points. The regional bank only took a $16 million provision for credit losses due to a focus on high net worth individuals without credit concerns, especially considering the loan balance is now $173.3 billion.

First Republic announced plans to reduce the workforce by 20-25% in a sign of the dire position of the bank. The bank spent $852 million on noninterest expenses during Q1'23 suggesting the cut in employees and executive salaries might save in the range of $200 to $250 million per quarter going forward.

The NIM will likely be under massive pressure with funding costs rising either via the bank paying more to retain existing deposits or the amount the company is paying for borrowings. The bank now advertises a special 5-month CD rate at 4.95%, which is far above the rate First Republic obtains from their average loans.

Analysts were already forecasting the bank would produce massive losses in the next 4 to 5 quarters. The regional bank failing to match analyst estimates for deposits isn't a good sign First Republic hits even these dire EPS losses.

First Republic only produced a Q1 net income of $269 million and just a minimal increase to funding costs on a combined $211 billion in the range of 50 bps wipes out this income level. With the noninterest expense savings, the bank could probably absorb up to 100 bps of higher costs before profits are wiped out and the shift to borrowings costing more than 4% on average is far more than 100 bps ..

Considering the regional bank plans to cut bank employees and decrease loan balances, First Republic won't be adding higher rate loans to the balance sheet to cover the higher funding costs. The scenario isn't positive for First Republic to turn around the business.

Takeaway

The key investor takeaway is that First Republic management didn't provide a lot of confidence with an earnings call that didn't allow questions. FRC stock won't rally until solutions to the current flawed business model are solved.

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