IBTX - Special Situations Report: Deep Dive Into Banking Sector Dynamics Uncovers Independent Bank

2023-11-18 03:03:42 ET

Summary

• The study identifies investment opportunities in the banking sector due to recent shifts in the financial landscape.
• Independent Bank Group emerges as an attractive opportunity with a target price of $47, presenting a 30% upside and a manageable 15% downside risk.
• Concerns about a commercial real estate crisis and its impact on banks may be somewhat exaggerated, and well-managed banks in regions with favorable economic conditions offer prudent investment opportunities.

Investment Thesis

This study initially set out to evaluate vulnerabilities within the banking sector, considering potential short positions. Key concerns raised by investors included Net Interest Margin ((NIM)) compression, uncertainties surrounding true Tangible Book Value ((TBV)) with unrealized losses, and worries about commercial real estate ((CRE)) exposure and a potential recession. To address these concerns, the study focused on banks with significant CRE exposure, honing in on Independent Bank Group ( IBTX ) as a case study.

In conclusion, the study uncovered an investment opportunity in the banking sector due to recent shifts in the financial landscape. Despite initial concerns about deposit flight, the investigation evolved into recognizing hidden potential within undervalued banks. Specifically, IBTX emerged as an attractive opportunity with a target price of $47, presenting a 30% upside and a manageable 15% downside risk.

Concerns about an imminent commercial real estate crisis and its impact on banks have persisted. However, it is crucial to acknowledge that banks have fortified their positions over time, accumulating reserves and bolstering capital. While valid concerns about a severe recession or CRE downturn exist, the likelihood of these challenges significantly affecting banks is somewhat diminished. The case of IBTX, with substantial Commercial Real Estate loans, suggests industry-wide concerns may be somewhat exaggerated. Despite this outlook, exploring investment opportunities in regions with favorable economic conditions and well-managed banks remains prudent.

Moreover, our confidence in the stabilization of cash sorting at banks like IBTX, leading to an improvement in NIM, remains strong. As the Federal Reserve approaches a terminal rate, the banking sector is believed to be entering a stabilizing phase. Deposit betas, which measure deposit rate responsiveness to market interest rate changes, remain below one, indicating a manageable impact on deposit rates. Evidence also suggests a decline in FHLB loan advances and the Bank Term Funding Program, as demonstrated by IBTX, indicating a shift in funding dynamics within the banking sector.

Examining IBTX's capital ratios under extreme conditions, including all unrealized losses, affirms the bank's robust capitalization. With a current CET1 to risk-weighted assets ratio of 10%, even after adjustments, IBTX demonstrates resilience. Anticipated interest rate hikes of 25 basis points are not expected to significantly impact the CET1 ratio, remaining above the prudent threshold of 6.5%. The risk mitigation analysis extends to the HTM portfolio, minimizing the potential decline in tangible book value to $30, reinforcing IBTX's stability.

Concerns about increased loan defaults in an economic downturn are valid, but banks like IBTX have proactively prepared for such scenarios. Proactive measures, including enhancing loan portfolios, fortifying capital positions, and bolstering loan loss reserves, have been undertaken. While varying among institutions, these measures collectively contribute to a level of prudence and readiness in the face of potential economic challenges.

IBTX Business Strategy

The Company's strategic approach is underpinned by two fundamental pillars.

First, the Company prioritizes organic growth, leveraging its existing network and business lines. This growth strategy centers on a community-focused and relationship-driven approach to increase loans and deposits within the Company's current locations in Texas and Colorado. Preserving the soundness of the loan portfolio is integral to this strategy, underpinned by a robust and conservative credit culture.

Second, the Company seeks growth through strategic acquisitions. It intends to capitalize on opportunities to acquire or partner with other banking franchises, both within and outside its existing footprint. Over the past decade, the Company has completed twelve acquisitions expanding its market presence.

Banking Services

In terms of lending operations, the Company offers a diverse range of commercial and retail lending products to businesses, professionals, and individuals. These offerings include owner-occupied commercial real estate loans, interim construction loans, commercial loans (including Small Business Administration guaranteed loans), business term loans, equipment lease financing, lines of credit, and energy-related loans. The Company serves a mix of small and mid-sized businesses and professionals, including medical practices, and offers retail lending products encompassing residential first and second mortgage loans and consumer installment loans for items such as cars, boats, and recreational vehicles. The Company's strategy involves maintaining a broadly diversified loan portfolio across different types and locations, including real estate loans, commercial and industrial loans, residential mortgage loans, residential construction loans, agricultural loans, consumer loans, and energy loans. Geographically, these loans are diversified across the Dallas/North Texas, Houston, Austin/Central Texas, and Colorado Front Range regions.

Regarding deposits, the Company provides a comprehensive suite of deposit products and services, encompassing checking and savings accounts, debit cards, online banking, mobile banking, eStatements, bank-by-mail, and direct deposit services. Deposits serve as the Company's primary source of funds for lending and general banking activities. Business accounts and management services, including analyzed business checking, business savings, and treasury management services, are also offered. The Company solicits deposits through a relationship-driven team and community-focused marketing, with an experienced Treasury Management team managing large deposit relationships.

Furthermore, the Company extends its services to include residential mortgages through a mortgage brokerage division. As a mortgage broker, it originates residential mortgages typically sold into the secondary market post-closing. Wealth management services are also available to customers through Private Capital Management, LLC, a registered investment advisory firm and wholly owned subsidiary of the bank. The Company has introduced a retail banking strategy aimed at enhancing the consumer experience by diligently addressing the multifaceted financial needs of individual customers within its financial centers.

Loan Portfolio

The Impact of Rising Interest Rates / Deposit Migration / Fed Advance balances / CET1 tests / AOCI:

The implications of escalating interest rates represent a legitimate concern, warranting a closer examination. Investor apprehensions surrounding rising interest rates can be categorized into three primary areas:

• One concern revolves around whether deposits are being redirected to seek better interest rates elsewhere.
• Another aspect involves assessing whether the bank is compelled to substitute departing deposits with loans obtained from the Federal Reserve or Federal Home Loan Bank (FHLB).
• Impact on Unrealized Losses in Available-for-Sale (AFS) Portfolio: Investors are also keen to understand the dynamics of unrealized losses within the AFS portfolio. In particular, the inclusion of Accumulated Other Comprehensive Income (AOCI) and its effect on the Common Equity Tier 1 (CET1) measure is a focal point. Additionally, there is scrutiny regarding the repercussions of unrealized losses within the Held-to-Maturity ((HTM)) portfolio.

Delving into these considerations is essential to comprehensively address the multifaceted impact of rising interest rates on the financial landscape.

Various theories abound regarding how rising interest rates affect banks, and different individuals subscribe to distinct interpretations.

The first theory posits that escalating interest rates might induce economic upheaval, potentially leading to a surge in loan defaults and consequent damage to banks' loan portfolios. This scenario has been partially addressed in previous points and is contingent on a scenario where the economy faces a severe implosion, not just a recession. Such a dire situation would undoubtedly call for caution in investing in banks.

The second theory holds that rising interest rates erode banks' earnings, a notion that appears somewhat perplexing. Historically, banks have adhered to the principle of borrowing short-term funds to lend long-term. Paradoxically, the most challenging environment for banks materialized during the first and second quarters of a given year when short-term interest rates significantly exceeded long-term rates. However, the recent increase in interest rates has seen short-term rates remain relatively stable while long-term rates have risen. This scenario is more favorable for banks than the prior Q1/Q2 example. Banks fundamentally operate in an interest rate-sensitive realm, and this principle has remained unaltered, notwithstanding the occurrences related to SIVB and FRC. Deposit betas, which measure the responsiveness of deposit rates to changes in market interest rates, typically remain below one. Many banks exhibit deposit betas in the 50-60% range, signifying that for every 1% movement in interest rates, these banks need to pay an additional 50-60 basis points in interest on their deposits. As a significant proportion of bank loans are floating rate, rising interest rates can augment profitability. With a less inverted yield curve and stabilized deposit betas, bank earnings are poised to experience substantial growth.

In summary, despite various prevailing theories and concerns, the outlook for banks in the context of rising interest rates is characterized by positive indicators, potentially heralding a period of robust earnings and profitability.

We have confidence that the stabilization of cash sorting will drive an improvement in Net Interest Margin ((NIM)), despite initial concerns about NIM compression caused by rising interest rates. As the Federal Reserve approaches a terminal rate, we believe we are in the early stages of this stabilizing phase within the banking sector.

Taking IBTX as a case study, we can examine recent changes in its deposit profile and rates. Management's belief in the commencement of loan repricing to higher rates is supported by several factors:

Improved Loan Yield: During the third quarter, management reported an increase in loan yields, with a significant portion of new loan production occurring in the last two weeks of that quarter. This indicates that newly originated loans carried higher interest rates, contributing to improved loan yields.

Strong Loan Production: Management anticipates over $2 billion in contractual loan roll-ins (repricing) in 2024. This substantial volume of loans coming up for repricing suggests that as these loans mature and reset at current market rates, they are likely to carry higher interest rates, positively impacting loan yields.

Competitive Pricing Strategy: Management has adopted a proactive and competitive approach to pricing loans in response to changes in the interest rate environment. This strategy aims to ensure fair compensation for the risk involved in originating loans and capture higher rates as market conditions evolve.

In summary, management's confidence in the initiation of loan repricing to higher rates is founded on their observations of improved loan yields, a significant volume of loans scheduled for repricing in 2024, a competitive and proactive pricing strategy, and adaptability to changing market conditions. This confidence underscores their belief in the bank's capacity to capitalize on higher loan yields as existing loans reset at market rates.

FHLB and Borrowings are also declining. Additionally, we have observed indications that the peak of FHLB loan advances and the Bank Term Funding Program has occurred in the middle of 2023, and there is now a discernible plateau. Our analysis, as demonstrated by the IBTX case study, reveals a declining trend in FHLB loans.

Risks

A frequently raised issue is the potential vulnerability of banks in the face of an economic downturn that could lead to increased loan defaults, which is a valid point of contention as well.

Let us begin by acknowledging that the banking sector has encountered economic recessions in the past. It is essential to remember that banks have had an extended period to ready themselves for the impending economic downturn. Notably, last year's consensus among economists anticipated the onset of a recession. This forewarning provided banks with ample time to make preparations, and they have done so through various strategic measures.

People often wonder if an impending commercial real estate crisis might spell trouble for banks. Despite the industry-wide concerns surrounding Commercial Real Estate, it is noteworthy that the Non-Performing Loans (NPLs) and Net Charge-Offs (NCOs) as a percentage of their portfolio remain historically low. Furthermore, there is a discernible trend of decline in these indicators.

Valuation

In our exploration of community and regional banks within the $15-20 billion asset range, the current market positioning of Independent Bank Group, Inc. ( IBTX ) reveals a slight discount, primarily attributed to lower Net Interest Margin ((NIM)) and suboptimal return metrics when compared to industry benchmarks. However, our optimism is buoyed by the anticipation of the Federal Reserve's interest rate hiking cycle conclusion, coupled with management's communication on loan repricing, which we believe will likely result in an improvement in NIM and associated return metrics.

One notable strength in IBTX's profile lies in its conservative approach to risk management. The bank exhibits a robust safety buffer, evident in its Non-Performing Loans (NPLs) and Net Charge-Off ((NCO)) ratios relative to its total loan portfolio. This cautious strategy positions IBTX favorably for potential alignment with peer Price-to-Tangible Book Value (P/TBV) multiples of 1.5x versus the current 1.16x.

Further contributing to the bank's risk mitigation is its relatively small Held-to-Maturity ((HTM)) portfolio. With a portfolio size of $207 million and minimal unrealized losses amounting to $60 million, the risk to the actual tangible book value from further erosion is minimal if the HTM assets are reclassified as Available-for-Sale (AFS).

The recent interest rate hikes are underscored by a $50 million increase in unrealized losses within the AFS portfolio between Q2 and Q3 2023. In anticipation of a 25 basis points rate hike, our analysis suggests that additional losses on the AFS portfolio are unlikely to exceed $50 million, limiting the potential decline in tangible book value to $30.

Taking these considerations into account, our projection outlines a favorable risk-reward profile for IBTX, estimating an upside of approximately $47. This optimistic outlook is counterbalanced by a downside range of $30, constituting a 35% upside and a more conservative downside of 15%.

In tandem with our valuation discussion, we integrate a Discounted Cash Flow ((DCF)) model driven by conservative assumptions and projections. Initiating with a measured assumption of 4% loan growth in the coming years, followed by a shift to a more stable growth trajectory of 5- 7%, our model reflects a balanced outlook considering both short-term dynamics and the sustainability of IBTX's long-term performance.

Looking ahead, the DCF model foresees an improvement in IBTX's NIM, projecting a transition from the current 2.8% to just under 4% over the next 3-4 years. This optimistic forecast aligns seamlessly with insights derived from our peer-based valuation analysis, emphasizing the potential for enhanced profitability in the foreseeable future.

Central to our DCF model is the consideration of a perpetuity growth rate set at 6%. In assessing inherent risks, our DCF model employs a discount rate of 15%. The synthesis of these inputs within the DCF model yields a target price of $45.

Importantly, the alignment observed between our peer-based valuation and the DCF model instills confidence, leading us to express comfort in the mid-point valuation of $46.

Representing an encouraging upside of 30%, this figure encapsulates the holistic nature of our analysis, blending relative industry performance with intrinsic financial considerations.

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