HTH - Hilltop Holdings: Ample Capital And Ample Opportunity But Will They Execute?

2023-10-23 15:43:00 ET

Summary

• Hilltop Holdings reported better-than-expected Q3 earnings, with decent performance in the core banking and securities operations, and a smaller loss in the mortgage banking operations.
• The bank's core banking operations are facing challenges such as softening loan demand, deteriorating credit quality, and pressure on deposit costs, particularly with above-average non-interest-bearing deposit erosion.
• Hilltop has a strong capital position and has returned meaningful capital to shareholders through buybacks, but there is a need for more aggressive growth strategies in the core banking business.
• The importance of the mortgage banking business, and the difficulty of forecasting interest rates, add to modeling complexity here.
• Double-digit earnings growth can support a fair value in the $30s, with upside potential in mortgage banking, but I'd like to see more attention paid to growing/improving core banking ops.

Texas-based Hilltop Holdings ( HTH ) may be one of the most confounding banks I follow (and that's a list that includes Westamerica (WABC), a bank that doesn't seem to like making loans). I've liked a lot of what this company has done over the years, including building out its securities business and returning considerable capital to shareholders. But I've also found some of management's choices puzzling - including the decision to not more aggressively take advantage of M&A disruptions in Texas by hiring productive banking teams to grow the business.

Hilltop has a good per-share growth track record, including double-digit tangible book value growth, but that's counterbalanced by a business mix that is heavily reliant on lower rates. The bank is flush with capital and could be more active in M&A or organic hiring, but I don't know if they will, and I do know that the bank has been losing share in the highly competitive (and attractive) Texas banking market.

All of this makes for challenging modeling and valuation. I believe that mortgage banking will recover in a couple of years (2025 and beyond), and I think double-digit growth from the low starting point of 2022 earnings is very plausible, but there are a lot of strategic unknowns at this point that adds to the risk of this story.

Better Than Expected Earnings, With A Caveat

Hilltop reported better than expected third quarter earnings, but that comes with the caveat that earnings here tend to be more difficult to predict and historically there have been bigger spreads between reported results and sell-side estimates than for other banks of similar size. A lot of that comes from the challenges of modeling mortgage banking - a business that has generated more than half of revenue in the past.

Revenue fell more than 5% year-over-year this quarter, but rose about 1% quarter-over-quarter, beating by around 4%. Net interest income declined 6% yoy and 2% qoq, which was a surprisingly typical performance for the quarter. Net interest margin rose 1bp sequentially to 3.04% (up 3bp to 2.97% on a core basis) while earning assets declined about 3%. The banking business generates the bulk of the net interest income (down 2% to $99M this quarter), but the securities business generates some (down more than 7% to $12M) from securities lending.

Non-interest income declined 5% yoy and rose 3% qoq to $197M. Core banking generated fees of a little under $12M, up 4% qoq, while mortgage banking generated almost $89M (down 1.5%) and securities generated more than $106M (up 6.4%).

Operating expenses fell almost 3% sequentially, with a pretty terrible-looking efficiency ratio of over 83%. The core banking operations generated a decent ER of around 51% (opex down 1% on a 1% revenue decline), but operating expenses exceeded revenue in the mortgage banking business.

Pre-provision profits rose more than 25% yoy and qoq. Core banking saw a 2% sequential PPOP decline (to almost $54M), while securities generated 13% growth (to almost $21M), and mortgage banking produced a smaller loss (about $8M). Corporate expenses account for the differences.

A Familiar Story In Core Banking

Not much about what's happening in the core banking operations at Hilltop is surprising. Loan demand is softening (loans fell 2% qoq), credit quality is starting to deteriorate (but not sharply), and deposit costs are a significant source of pressure.

Unfortunately, Hilltop's loan detail/disclosure isn't the best, so that makes analysis a little more challenging. Within that 2% sequential loan decline, CRE lending actually grew a little less than 1% and kept pace with the broader banking sector. C&I lending was down sharply (down 11%), but this is where mortgage warehouse lending goes and that drove a lot of the decline - management said that mortgage warehouse lending declined by $90M sequentially and that that accounted for the "majority" of the decline, but I calculate a $197M sequential decline. Construction and mortgage lending both declined by about 2%.

Loan yields improved 10bp sequentially to 6.31%, and Hilltop's cumulative loan beta of around 43% isn't too bad.

On the credit side, the NPA and NPL ratios were both stable (reported non-performing loans declined 19% qoq) and the company actually reported net recoveries for the quarter (as opposed to charge-offs). The reserve ratio of 1.35% looks fine, with a 2.1% CRE reserve; curiously, construction loans have a low 0.8% reserve ratio - odd as this can be a risky lending line (but not all construction loans are the same).

Hilltop does have a meaningful exposure to office lending, with non-owner-occupied office CRE loans making up 6% of total loans and more than a quarter of the non-owner-occupied portfolio. This a watch item for the future as management hasn't disclosed as many details as other banks (splits between Class A/B/C, splits between traditional offices and medical offices, LTVs, and so on).

Looking at funding, deposits fell less than 1% qoq, but non-interest-bearing deposits dropped more than 7% and that's worse than average for banks this quarter so far. Deposit costs are on the high side as well, with interest-bearing deposits up to 3.2% and total deposit costs at 2.3%; the cumulative beta of 62% is on the high side as well, particularly in the context of non-interest-bearing deposits making up close to 30% of deposits (that was closer to 40% a year ago).

Plenty Of Deployable Capital

While CET1 can be something of a blunt instrument when it comes to comparing capital positions, the reality is that a CET1 ratio of 18.6% pretty accurately captures the strong capital position here (likewise a TCE ratio above 11%).

Management hasn't been very acquisitive in recent years, and a lot of that surplus capital has gone back to shareholders in the form of dividends and buybacks - the share count has dropped by almost a third since 2018.

At the same time, though, management has actively built up the securities business, adding capabilities (like commodities) and building up areas like fixed income, public, and structured finance across the country by hiring experienced bankers from established companies.

I'd like to see the same for the core banking business. Hilltop has lost about a half-point of market share in Texas's deposit market in around three years and fallen out of the top 10, including larger share losses in its core Dallas market. This market has attracted a lot of attention from larger banks outside the state, and I think Hilltop needs to step up its own efforts. Pinnacle ( PNFP ) has shown that hiring away skilled and experienced revenue-producers can generate strong results, and I'd like to see an organic growth plan here predicated on something similar.

The Outlook

Modeling Hilltop is challenging because the mortgage banking and securities business are both significantly influenced by interest rates (more so the mortgage business). I'm not expecting a big improvement in mortgage volumes until rates start falling (hopefully 2H'24), but I do think this business can recover in 2025 and beyond. In the meantime, I think all of these businesses are basically in "muddle-through" mode, though the securities business seems to be doing alright.

My current modeling assumptions see Hilltop generating mid-teens core earnings growth over the next five years on a mortgage banking (and regular banking) recovery and long-term growth in the low double-digits. Even with those assumptions, Hilltop wouldn't recover peak 2020 earnings in my forecast period. Accordingly, a stronger recovery in mortgage banking could drive a lot of upside, as could more growth-oriented investment into the core banking operations (hiring more loan officers and taking more loan share).

Discounting those base-case core earnings I get a fair value of around $31. Multiples-based approaches are less useful here; the fair value won't look on the basis of likely earnings/ROTCE in 2023 or 2024, but I don't think those are representative of long-term profitability or earnings power. I can apply a 12.5x multiple to my 2025 EPS estimate and discount back, and likewise apply a 1.05x multiple to TBV on the basis of my 2025 ROTCE estimate, both of which get me to $29/share, but there's plenty of guesswork there.

The Bottom Line

Even with the modeling challenges, I feel fairly confident saying that Hilltop is a name to consider if you want a bank highly leveraged to lower rates. That's not something I expect in the short term, and that will create ongoing challenges for the business, but at some point, the Street will switch over to picking winners when the Fed starts loosening. While I can model scenarios that drive much higher fair values, there's more risk and uncertainty here than most, and I'm not as keen on the shares now, though that could change if management lays out a clearer plan to drive stronger long-term performance in the core banking operations.

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