RF - Regions Financial Showing It's All-Weather Qualities

2023-07-24 11:09:00 ET

Summary

• Regions Financial reported mixed second quarter results with on-target net interest income, better fee-based income, and higher expenses driven by unusual fraud-related expenses.
• This Southeastern bank continues to show the strength of its deposit franchise, with best-in-class deposit betas and attractive funding costs relative to many peers.
• Slowing loan demand and higher credit losses are near-term threats to growth and there is considerable uncertainty today about future capital requirements as regulators mull new rules.
• Regions is built to thrive over the longer term; while these shares aren't likely to offer the highest alpha in a bank recovery scenario, they still offer a decent mix of quality and upside.

I can’t say that Regions Financial ( RF ) has done well since my last update on this Southeastern super-regional bank, but the shares have outperformed a blended peer group average by a little over 10%, which does at least support the idea that this is a well-run bank that is built to withstand tough times.

I believe that demonstrated quality also explains why these shares aren’t especially cheap, or at least not as cheap as many other regional banks. I still see worthwhile upside (into the low-to-mid-$20’s), but there are other banks better-suited to outperform if and when the macro environment turns more positive for the sector. Still, for investors who want a dependable bank stock where they don’t have to have to worry about timing the cycles, this remains a worthwhile name to consider.

A Mixed Quarter That Was Arguably A Bit Better Than It Appears

Bank earnings are always a little challenging to analyze, and the bigger the bank, the more adjustments you have to be prepared to make to get a sense of the true “core” earnings of the business. That was true with Regions this quarter, as earnings on a core reported basis weren’t quite as good as investors wanted, though I believe the adjusted numbers (the “core core”, as it were) were better.

Revenue rose a little less than 14% year over year and declined about 1% quarter over quarter, good for a small ($0.02/share) beat. Net interest income was slightly ahead of expectations, growing more than 24% yoy and falling almost 3% qoq. While Regions did miss slightly on net interest margin (4.04%, down 18bp qoq and missing by about 3bp), most banks are missing on NIM as analysts continue to underestimate the impact of higher deposit costs. On the flip side, Regions showed greater-than-expected balance sheet growth, with earning assets growing about 0.5% qoq and beating expectations by about 2%.

Fee-based income was a source of strength relative to expectations, driving revenue upside this quarter and growing 3% qoq (down almost 6% yoy). While mortgage banking, deposit charges, and capital markets were all down year over year, the bank is seeing better results from wealth management and treasury management and the worst should be over for the mortgage banking and deposit line-items.

Expenses is where things get a bit more complicated. Operating expenses rose about 17% yoy and 8% qoq, driving close to $0.05/share of downside. About $82M of opex was driven by issues relating to check fraud that management had previously disclosed, and management believes they have addressed this issue. Strip that out and Regions beat on opex (though sell-side estimates did factor in some of this expense given prior guidance. I don’t have strong opinions as to whether investors should overlook this – it is an unusual expense, but also a byproduct of the bank’s policy to create/operate customer-friendly products – but if management has shored up the weaknesses that allowed this to happen it’s a moot point.

With those expenses, pre-provision profits rose about 10% yoy and fell 11% qoq, missing by $0.03/share (or beating by $0.04/share without them). Lower provisioning expense and a lower tax rate compensated for the opex overage, but those are lower-quality sources of upside.

“Steady As She Goes” In Unsteady Times

Unlike many banks, the guidance from Regions really didn’t have any troubling surprises. Management reiterated its guidance for net interest income growth (up 12% to 14%) and revenue growth (up 6% to 8%) and likewise reiterated its expense guide (up 6.5%) that had been raised prior to the quarter due to the fraud issue.

Loan growth expectations go up slightly (from “up 3% to 4%” to up 4%), while deposit shrinkage is a little worse (“modestly lower” in the second half versus “stable to slight growth” previously). The latter is indeed a modest negative, but not really surprising given the prevailing circumstances.

Regions continues to benefit from its differentiated deposit base. Unlike many large banks, Regions’ deposit base consists of numerous smaller retail deposits, and this bank is not all that reliant on large uninsured deposits from retail or commercial customers. To that end, around three-quarters of its deposits are insured and Regions continues to have one of the lowest deposit betas (both interest-bearing and total), with a total cumulative deposit beta in the mid-teens, slightly below Commerce ( CBSH ), and below the likes of Bank of America ( BAC ), Comerica ( CMA ), and Wells Fargo ( WFC ), all of which have comparatively good (compared to the large bank group, that is) betas in the low-to-mid-20%’s.

I can’t say there’s no risk on the funding side. Deposit betas are still going to rise from here (management is targeting a year-end cumulative interest-bearing deposit beta of 35% versus 26% today), and that number could go higher still if monetary policy remains tight. Likewise, while Regions still compares very well with peers in terms of no/low-cost deposit retention, non-interest-bearing deposits did decline 20% yoy and 6% qoq in the quarter, with deposit costs up 77bp yoy and 27bp qoq (versus peer-average increases of about 180bp and 45bp). Management also had to turn to brokered deposits to offset deposit outflows, adding about $1B in higher-cost brokered deposits this quarter.

There’s also still some risk on credit, though I think Regions has better-than-average underwriting quality. Charge-offs were stable on a sequential basis (0.33% vs. 0.35%) and commercial loan charge-off rates remain healthy (0.24% vs. 0.31% in Q1’23), and non-performing loans actually declined about 11% sequentially.

Looking at the loan portfolio, I’d call Regions’ exposures generally positive. At around 10%, Regions isn’t overly exposed to commercial real estate lending (Comerica is over 20%, M&T Bank ( MTB ) is at 25%, and Bank OZK ( OZK ) is at 60%), though its roughly 2% office exposure skews very slightly high. Then again, that office exposure is largely Class A (over 90%) and predominantly suburban; while Regions’ reserving here looks low (2.7%), management believes that is supported by low LTVs and a lower likelihood for distress in suburban office given lower supply levels compared to urban. Still, I’d call this a watch item.

More Moderate Growth Prospects And Some Capital Concerns

Loan growth is going to get more challenging from here. Higher rates have cooled the mortgage market and businesses are pulling back on investments/expansion, leading to lower demand for loans. Regions still managed to outgrow the sector for C&I loan growth (up about 1% qoq this quarter), but I’m not looking for robust near-term loan growth given the economy.

On the other hand, Regions is putting some loans on the books at attractive rates, and combined with a hedging program, I do like the prospects for the bank maintaining healthy (3.6%+) NIM’s despite the likelihood of lower rates in 2024 and beyond.

On the capital side, uncertainty is the order of the day. New rules and regulations (Basel IV, FDIC special assessment, et al) are likely to require the bank to hold more capital. To that end, management said that they’re expecting a total loss absorbing capacity (aka TLAC) requirement of 6% of risk-weighted assets. In such a scenario the bank would look to a roughly $5B debt issuance and would probably see a 1.5% hit to net income. On a more positive note, unrealized losses in the available-for-sale securities portfolio should reverse over the next two and a half years.

All told, I think this means a slightly weaker earnings outlook for Regions, but not any more so than for other banks with $100B or more in assets that will now fall under new, more stringent regulation. Given the uncertainties, I expect management to be pretty conservative with capital (share buybacks, etc.), though management did raise the dividend 20%.

The Outlook

I still expect regions to be a low-to-mid single-digit core earnings grower over the longer term. The bank has a strong and attractive operating footprint across the Southeast/South and I expect this region to continue outgrowing national averages for population and income growth. There is significant competition, but Regions has shown that it has a strong core deposit base and I believe Regions is a long-term winner. While generally stronger on the retail side, I do see opportunities for further improvements in commercial lending/banking and that could be a possible source of upside.

Low-to-mid single-digit core earnings growth can support a fair value in the low-to-mid-$20’s on a discounted core earnings basis. I get similar results based on a ROTCE-driven P/TBV model (a 2.35x multiple on almost 19% ROTCE in 2024) and a 9.5x multiple to my 2023 EPS estimate. That multiple is rather low, appropriate given the challenges in the sector, and a rerating over time is likely in my mind.

The Bottom Line

There are banks that offer more upside than Regions today, but I think Regions does still offer a good mix of quality and value. Regions is more of a SWAN (“sleep well at night”) story than many regionals, and while not the best name for playing a bottoming/recovery thesis for banks, it’s an all-weather bank for investors who want quality long-term exposure to the Southeast region at a reasonable price.

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