TCBI - Independent Bank Group Working Through A Challenging Bottleneck

Summary

• Independent's fourth quarter results were noticeably different than those of most banks, with a contraction in net interest income and net interest margin and weak pre-provision profit performance.
• The nature of IBTX's loan book means that it's seeing less uplift from higher rates today, but those benefits will start to show over the next year, driving better results.
• IBTX could be an interesting option for investors who want a bank with meaningfully different near-term drivers, but the valuation isn't compelling enough for me.

These aren't easy times to be running a bank, as loan demand is trailing off, funding costs are rising quickly, and the path for credit quality is unclear, but almost certainly worse to some extent. Independent Bank Group ( IBTX ) has an added challenge on top of those - the nature of the bank's loan book is such that rising deposit costs are significantly outstripping earning asset yields as the loan book is slow to reprice. That puts more pressure on spread income in the short term, though Independent could enjoy a longer tailwind from the loans that do reprice during this period of higher rates.

I can't say I'm all that fond of these shares here. I do think Independent is poised to be something of a contrarian, growing spreads at a time when other banks are seeing them contract and under-earning in the short run, but likely posting better growth than many peers in 2024. Still, with a fair value range in the high-$50s to high-$60s, I think there are better names to consider.

Unusual Results In The Fourth Quarter To The Model

In part do the nature of the company's earning asset base and nature of its loan book, Independent's fourth quarter results look quite a bit different than those of banks of similar size. All in all, it was a rough quarter with not too many positive drivers.

Revenue rose just 4% year over year and fell almost 5% quarter over quarter, a definite outlier compared to the more typical 20%-plus year-over-year and 5%-plus quarter-over-quarter growth. It was also about 5% weaker than the Street expected (or around $0.17/share of headwind).

Net interest income rose 7% yoy and fell 4% qoq, missing sell-side expectations. Net interest margin rose 50bp yoy, but actually contracted 15bp qoq (to 3.52%). Earning assets fell 8% yoy and were up slightly from the prior quarter. Non-interest income was also weak, falling 23% yoy and 13% qoq due to weakness in its mortgage banking and mortgage warehouse businesses.

Operating expenses rose more than 15% yoy and about 2% qoq (adjusted). Pre-provision profits fell about 10% yoy and almost 13% qoq, and this was a meaningful shortfall relative to Street expectations. Provisioning was a little better than expected, but all in all this was a weak quarter relative to expectations.

Following A Different Path On Spreads

It's important to understand deposit betas, the rate at which the cost of deposits changes in relation to the change in the Fed funds rate, to understand what's going on in banking right now, but deposit betas are only part of the picture. While it is indeed important to understand a bank's exposure/vulnerability to rapidly-rising funding costs, it's also important to understand how higher rates impact the earning assets on the balance sheet.

Independent's cumulative deposit beta was about 23% exiting this quarter, and that's on the lower side of average (so, not bad), and likewise with the 35% cumulative interest-bearing deposit beta. Look at Texas Capital ( TCBI ) and you see much higher betas - 32% and 59%, respectively. Nevertheless, Texas Capital posted around 4% qoq net interest income growth, with net interest margin improving 21bp qoq.

This is where loan/asset betas enter the picture. Because of the nature of Independent's loan book (fixed/variable, floors, etc), this bank is seeing its loans repricing less quickly. Loan yields improved about 66bp yoy and 35bp qoq (to 5.04%, as reported) versus the 235bp/96bp improvement at Texas Capital. So, where Texas Capital's cumulative loan and earning asset betas are 54% and 55%, Independent's are around 19% and 29%.

The good news is that this will improve with time, and the bank is adding loans today at spot rates in the mid-to-high-7%'s. So where many banks will start seeing less and less benefit from high rates on their loan books (because they're more skewed to variable-rate commercial lending) but an increasing pinch from funding costs, Independent has already taken some of the hit from deposit costs but still has more left to gain on earning asset yields.

Along those lines, Independent's 31% ratio of non-interest-bearing deposits to deposits isn't bad, though the loan/deposit ratio (around 90%) is higher than I'd like.

Credit Is A Concern To Me

Independent's reported credit metrics looked okay, with a low charge-off rate and stable-to-lower non-performing loan and asset ratios. Moreover, while the reserve ratio isn't all that high (1.09%), it doesn't seem problematic relative to the bank's past loan loss experience.

Still, I think the credit situation bears watching. Commercial real estate (or CRE) is more than half of the loan book, and of that about 29% is in retail and 20% is in office - two of the categories that most concern me going into this downturn. I don't think we're about to see a serious recession, and I think Texas (where three-quarters of Independent's loans are located) will fare better, but given that retail and office operators really haven't had an opportunity to build up much of an "insulating layer" since the pandemic-driven challenges, I don't think it's unreasonable to have some concerns here.

The Outlook

Modeling Independent is a little challenging given its atypical earning asset betas, but I do think that mid-single-digit loan growth (management's target) is achievable in 2023, and I do think the company will see better spread leverage at a time when many banks will be seeing this metric shrink. Mortgage banking won't be much of a help in the short term, but I do think the business will eventually recover (likely 2024, adding more momentum to Independent's potentially differentiated growth profile then).

I'm a few pennies below the Street for both FY'23 and FY'24, but I do expect healthy growth from FY'24 on for several years. I'm looking for long-term core earnings growth of around 7%, and that may well prove conservative, particularly if Independent gets back to M&A in a meaningful way. Further diversification/expansion into other C&I lending lines would be welcome, but as management as said itself, they're not going to do it just to do it - it will be in areas they're confident they can generate attractive returns and not just to achieve growth for its own sake.

Discounting my long-term earnings estimates gives me a present-day fair value around $60. I get a wider spread between ROTCE-driven P/TBV (high-$50's) and P/E (high-$60's, using a 14x multiple), but that can be explained by the fact that the ROTCE-based methodology doesn't look ahead and reward growth in any meaningful way.

The Bottom Line

As long as the Fed is rising rates, it's hard to see bank stocks working, so it will likely be at least another few months at a minimum before sentiment starts to shift, and it may well take a more explicitly dovish stance to get bank stocks working again (and that may not happen until late in 2023 or in 2024). I do think Independent could stand out by virtue of a different bath for spreads and pre-provision profits over the next 12-24 months, but I don't see enough of a discount in the valuation to be more bullish today.

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