NYCB - OceanFirst Financial Looks Undervalued But Not Many Other Positives Jump Out

2023-10-23 01:53:36 ET

Summary

• OceanFirst's third quarter results were basically in line, with fairly typical net interest income performance, but weaker NIM and stronger AEA, and weaker profitability.
• Loan growth was nothing special and loan yields are comparatively weak, but repricings should help in 2024, deposit beta isn't bad, and NIM could trough in 2024.
• OceanFirst should be exiting a process improvement cycle and management is looking for improved operating leverage in Q4'23.
• The company's long-term growth metrics and ROE have been mediocre, and it needs to improve its Community Reinvestment Act compliance.
• OceanFirst stock could be substantially undervalued, and fundamental laggards tend to outperform when sectors turn, but there are many higher-quality undervalued banks today.

This latest phase of the banking cycle, largely characterized by a sharply higher Fed Funds rate, has not been an easy one for banks in general, and OceanFirst Financial ( OCFC ) has certainly seen some challenges. Down about 39% since my last update , OceanFirst had actually been outperforming the regional bank group until the last month or so, and I believe the more recent underperformance can be tied to growing concerns about the office commercial real estate (or CRE) market, an area where OceanFirst originates and holds a lot of loans.

My feelings about OceanFirst are very mixed. On one hand, I like the company’s plan to continue to take advantage of opportunities to disrupt significant Northeast/Mid-Atlantic markets, replicating a formula that has worked in markets like Philadelphia in markets like Baltimore, Boston, and Washington, DC. What’s more, given the meaningful M&A and market disruption over the past few years in the area, I think there are definitely opportunities.

On the other hand, OceanFirst’s return on equity and return on tangible equity numbers have never been great, the firm’s tangible book value per share growth has been below average, and the net promoter score is likewise mediocre. On top of that, the company has to improve its Community Reinvestment Act compliance, and this likely cost it its merger with Partners Bancorp .

OceanFirst does look undervalued, but it’s hard to advocate more strongly for this bank when there just aren’t that many attributes that stand out to the good and there are so many other undervalued banks today.

Evident Challenges In Q3, But OceanFirst Is Managing Them

I’d say that OceanFirst’s third quarter earnings were okay, but in the context of moderate expectations.

Revenue fell 7% year over year and a little more than 1% quarter over quarter, with net interest income down 5% yoy and about 1% qoq. Net interest income was driven by 11bp of sequential net interest margin erosion (to 2.91%, down 12bp to 2.85% on a core basis), though earnings assets did grow 1% sequentially (somewhat unusual this quarter). Non-interest income isn’t particularly significant (less than 10% of revenue), but core non-interest income fell 2% sequentially.

Core operating expenses rose more than 2% qoq, and the efficiency ratio of 64.3% is nothing special. Pre-provision profits declined more than 7% qoq, and annualized PPOP as a percentage of earning assets is a lackluster 1.2% (it was 1.7% a year ago). Tangible book value rose 1% sequentially, and company-reported return on average tangible common equity declined almost three points sequentially to 7.3%.

Repricing Should Help, But Core Balance Sheet Fundamentals Are Pretty Mixed

Due to an already high concentration of CRE loans and a high loan/deposit ratio, OceanFirst hasn’t been able to benefit as much as some banks from more stressed banks having to turn down more business and focus more on capital.

Loans were up less than 1% yoy in the quarter, underperforming the 4%-plus overall loan growth in the banking sector during the quarter. Commercial (C&I) lending was basically flat, underperforming 2% sector-wide growth, while CRE lending growth of 5% was likewise below the nearly 7% growth seen across the sector.

Loan yield improved 13bp qoq to 5.3%, which is below the 6% rate many banks are reporting this quarter. On a more positive note, yields on new loans are substantially higher (in 7.4%’s) and about 10% of the loan book reprices over the next year, so there will be some tailwinds here. The bank’s cumulative loan beta of 29%, though, is not so good.

Turning to deposits, total balances increased 6% yoy and almost 4% qoq, which is a solid performance. Likewise, the 21% year-over-year and 1.4% quarter-over-quarter decline in non-interest-bearing deposits is better than average, though a 17% ratio of NIB to total deposits is not so good. Deposit costs rose 163bp yoy and 47bp qoq to 1.99%, which actually isn’t bad relative to the low mix of NIB deposits, and the cumulative interest-bearing deposit beta of 43% is likewise not bad. The loan/deposit ratio, however, is quite high at 96%.

Looking at credit, non-performing assets did increase as a percentage of loans, from 0.17% in Q2’23 to 0.22%, and non-performing loans rose almost a third from the prior quarter (with a ratio of 0.30% vs. 0.23%). A single midtown Manhattan office credit drove much of this, but that serves to highlight some concerns about the portfolio.

Almost 11% of the bank’s total loans are categorized as office, though only about half that amount is what you’d consider traditional office – much of the difference is in medical offices where trends like work-from-home aren’t really relevant. A little more than 1% of loans are in central business district offices, and the criticized loan ratio of 2% is low. Even so, I expect the Street to be cautious around any bank with large office exposures, as new appraisals are only just starting to reflect the stress in the office category and many larger banks are boosting their reserves for office property loans to 8% or higher.

The securities book is not an issue – with a yield of 3.8% and a duration of 4 years, the bank actually has a small unrealized gain position here.

The Outlook

Management’s guidance suggests that NIM should bottom in the fourth quarter of 2023, and that’s likely earlier than most banks will see. Loan repricing will certainly help, and so far deposit costs remain quite manageable. I do expect the loan/deposit ratio to limit loan growth opportunities, though. Back on the positive side, management’s guidance suggests meaningful potential operating leverage next quarter and that bodes well for 2024, as I believe operating leverage at banks will be rewarded by the Street.

While there are some positives, I do have longer-standing concerns about this bank. Looking over the last decade, neither the revenue per share growth nor the tangible book value per share growth are above average (both are below average), and the long-term average return on equity has only been in the mid-7%’s. Likewise, the bank doesn’t score that highly on net promoter scores, which undermines the argument that the bank is going to be a disruptive player that actively takes share from larger banks like M&T ( MTB ), New York Community ( NYCB ), Toronto-Dominion ( TD ) and so on.

I do think the bank can grow core earnings around 4% to 5% over the long term, and that growth could be boosted by accretive M&A and/or further self-improvement. Those core earnings, discounted back, support a fair value in the mid-$18’s. Likewise, a forward P/E of 10.5x on my ’24 EPS estimate gets me to around $20 and a 10% ROTCE over 2024-2025 would support a 1.25x P/TBV and a fair value in the low $20’s.

The Bottom Line

There are preferred shares here (OCFCP) that offer a pretty attractive yield, and that may be something for readers to consider – The Investment Doctor has written on them a couple of times . For the common shares, though, I admit very mixed feelings. I do think there is an attractive opportunity that OceanFirst can serve, and I think there are still opportunities to grow via selective M&A. On the other hand, I don’t see as much positive differentiation here as I once did and there are so many undervalued banks to choose from today. Should sentiment on the banking sector turn, OceanFirst will likely outperform, but I prefer other names today even though I acknowledge what could be considerable undervaluation today.

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