IBTX - Independent Bank Group Likely Stuck Until There's More Clarity And Confidence Around Credit

2023-10-25 17:00:22 ET

Summary

• Independent Bank Group shares have fallen about 40% in the challenging rate cycle, with deposit costs shooting up and soft loan yield momentum.
• Third quarter earnings saw good opex control, but this was overshadowed by weaker spreads.
• Although IBTX's major office markets are in better shape than they may appear, a high skew to office lending and market jitters about the category will remain a headwind.
• Concerns about spreads and credit weigh heavily; IBTX could outperform on the other side of this credit cycle if losses remain low, but that's still some distance off.

Texas has been a hot banking market for many years, but that hasn’t spared Texas-based banks from the challenging rate cycle. Since my last writing , Independent Bank Group ( IBTX ) shares have fallen about 40%, more than 1,000bp worse than the performance of the broader regional bank group. Spread pressure has been intense, though credit has held up thus far.

I can’t say I’m all that much more positive on the shares today. High deposit costs are going to be a problem a while longer, and the asset side of the balance sheet has been slower to reprice than I’d previously expected. On top of that, the large CRE portfolio remains a credit risk; I’m not as negative on office properties in major Texas markets, but I don’t feel as good about strip mall retail. With shares that don’t look especially mispriced relative to other regional banks, and arguably a weaker set of near-term drivers, I don’t feel a need to get substantially more positive here, though if this bank maintains clean credit through this cycle, the shares should rebound on the other side of this cycle (still several quarters away, I believe).

Spreads Sap Earnings

Independent reported a 24% year-over-year and 4% quarter-over-quarter decline in revenue in the third quarter, about 4% worse than expected. Spread pressure was intense, driving a 26% yoy and 4% qoq decline in net interest income (FTE basis), as net interest margin declined 105bp yoy and 12bp qoq to 2.62% and earnings assets shrank by about 1%. Non-interest income isn’t an especially large part of the revenue mix (a little more than 10%), but declined 2% qoq on an adjusted basis.

Management did do surprisingly well on expense management, with opex down 8% yoy and 4% qoq on an adjusted core basis. Even so, the 65.8% efficiency ratio is high compared to similarly-sized banks. Pre-provision profits declined 42% yoy and 4% qoq, and profitability (as measured by PPOP as a percentage of earning assets) was just 1.02% versus 1.82% a year ago.

Provisioning has stayed steady at a low rate, and tangible book value per share fell about 1% both yoy and qoq.

Loans Look Okay, But Funding Is A Challenge

Loans rose more than 1% sequentially excluding mortgage warehouse lending, and that was better than what the banking sector as a whole managed in Q3’23. Commercial real estate (or CRE) lending grew a little more than 1% sequentially, above the market growth rate, and Independent likewise grew its construction loan book (up 3% in commercial, up 1.6% in residential), while commercial (or C&I) lending shrank slightly.

Yields were lackluster, improved about a point from the year-ago period and 16bp qoq to 5.7%, and the cumulative loan beta is only 28%. Overall earning asset yields likewise didn’t improve that much, with a cumulative earning asset beta of a 35.7%. For readers not familiar with beta in the context of banking, it basically measures how much a given rate (deposit costs, loan yields, et al) rise or fall in response to an underlying move in the Fed Funds rate.

For Independent, then, a greater than five-point increase in the Fed Funds rate has only translated into a roughly one and a half point increase in the loan yield. Loan yields will improve as loans reprice and new, higher-yielding, loans are originated, and about 15% of the loan book will reprice in 2024.

On the other side of the ledger, funding costs are shooting up. Independent has long run with a high loan/deposit ratio, and that doesn’t give it much leeway when deposit costs increase – the bank has to seek out new, more expensive funds to keep growing the loan book.

Deposits rose about 3% yoy and qoq this quarter (on an end-of-period basis), but non-interest-bearing-deposits fell more than 27% yoy and around 5% qoq. At around 25% of total deposits, the NIB ratio is lower than you’d like, and the bank has had to turn to more expensive CDs – time deposits nearly quadrupled from last year, with the cost of those deposits up more than three points (from just under 1% to just over 4.4%), and the bank is still advertising a 4.9% APY 11-month CD for retail customers, though that’s actually a little less than average now for the highest CD rate on offer.

Looking at deposit costs, total costs increased about 0.5% from the prior quarter to 2.7%, with interest-bearing costs up about 0.6% to 3.6%. The cumulative deposit beta of roughly 66% is one of the highest out there, and I don’t think we’re quite done with seeing rates head higher.

Credit A Concern, But Maybe Overblown

There’s widespread concern about CRE office loans in the market, as vacancy rates increase and appraised values fall. At almost 11% of total loans, Independent has a lot of office loans on its books, and even adjusting for owner-occupied and “non-traditional” properties, about half of that (5%) is more standard office properties.

Management doesn’t offer a lot of detail about the portfolio, like loan-to-value or breakdowns by property class, but my understanding is that the bank doesn’t do a lot of lending at the highest end of the market, and that’s the part that has held up better. On the other hand, while vacancies in Dallas, Houston, and Denver are high relative to national averages (around 25% to 30% versus mid-teens), higher-than-average vacancies are normal for these cities and rents haven’t really softened too much yet.

I fully grant that “yet” may be the operative word, though, and this is definitely a watch item, particularly with 2.5% of the CRE book now listed as “special mention” or “substandard” and close to 6% listed as something other than “pass”.

Given that work-from-home hasn’t been as strong of a trend in markets like Texas and given the ongoing net migration into Texas, I’m more concerned about the 17% of the loan book that is in retail. If consumer spending softens significantly, this could be an underappreciated risk relative to office properties.

Either way, while non-performing asset ratios have been stable and charge-offs are still low, credit concerns are likely to loom over the stock for another year as the credit cycle plays out.

The Outlook

I’m slightly below the Street for 2023 earnings and more substantially below the Street on 2024 earnings (if 3%-4% is “substantial”). I do still expect long-term core earnings growth of around 6%, but it will take some time to return to growth and those credit concerns in the CRE book are not going to go away quickly. There are still things I like about this bank, including its efforts to grow in areas like equipment finance, its avoidance of syndicated loans, and its strategy of targeting middle-market loan growth by hiring away productive teams from other banks. I just think this is a tough environment to make much headway, particularly given the high deposit beta.

Discounted core earnings do support a fair value in the mid-$40’s. Multiples-based approaches (ROTCE-based P/TBV and P/E) are more problematic. The shares look basically fairly-valued by these approaches, but it’s also true that the near-term financial performance is likely not reflective of the true long-term earnings power of the bank. It’s possible to go further out for more representative numbers and then discount back, but at a certain point that process risks becoming a “choose your target price, then work backwards to justify it” sort of exercise.

The Bottom Line

I think Independent goes into the bucket of banks that could see significant share price appreciation if and when the company’s credit holds up through this next phase of the cycle and the market returns to bank stocks - likely not until the second half of 2024 given the expectations for Fed rate moves. With that, this company and these shares are worth monitoring, but I don’t feel the need to get ahead of the story at this point.

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