TCBI - Texas Capital Bancshares Redesigning The Plane In Midflight

Summary

• Texas Capital's fourth quarter had something for bulls and bears, with a healthy pre-provision beat but significantly higher provisioning expenses and rapidly-rising deposit costs.
• I believe Texas Capital is still in the process of restructuring and remaking the business, and a lot of the negative spread and credit drivers are tied to legacy decisions.
• My expectations of low-to-mid-teens core earnings growth are by no means conservative, but I think Texas Capital is pursuing a much better strategy.
• Elevated near-term risks and valuation keep me cautious, but this is a name I'd revisit if there were a disproportionate selloff.

Management at Texas Capital Bancshares ( TCBI ) has moved actively and aggressively to restructure the business toward a more sustainable, more profitable, and less cyclical business over the long term, including efforts to remake the loan book, the deposit base, and the revenue composition. That’s a lot to tackle in a short time, particularly in unusually volatile banking markets, but management continues to execute well to the plan.

I was skittish about the short-term prospects when I last wrote about Texas Capital , and this is why I don’t pretend to be a market-timer, as the shares have done rather well since then (up more than 7% in about a month), with the shares enjoying a nice move post-earnings. I still see elevated near-term risks, with Texas Capital likely to see substantially higher funding costs and credit is more of a concern now. That said, I still remain a believer in the long-term direction of this bank, and were the shares to sell off into the low-$50’s (without a significant fundamental driver), I’d definitely reconsider a more bullish stance.

A Pre-Provision Beat, But A Lot Of Moving Parts

Generally speaking I care most about pre-provision earnings from banks, and Texas Capital did quite well here. At the same time, though, credit quality matters and provisioning expense isn’t a driver to be ignored, particularly when credit quality appears to be weakening.

Texas Capital reported 26% year-over-year and almost 5% quarter-over-quarter revenue growth in the fourth quarter, beating by around 2% (or close to $0.09/share). Net interest income rose almost 28% yoy and 4% qoq, making up about $0.04/share of that top-line beat. Net interest income was driven by net interest margin improvement (up 114bp yoy and 21bp qoq to 3.26%), while earning assets shrank almost 4% sequentially – one of the biggest declines I’ve seen this quarter.

Growing non-interest income is a major priority for management, and there is ongoing evidence of progress here. Non-interest income rose 12% yoy and about 15% qoq, making up the other $0.05/share of the top-line beat (relative to the Street). While Treasury income shrank (down 5% qoq), as did Wealth/Trust (down 6%), the capital markets business was up a strong 53%.

Operating expenses rose 24% yoy and just 1% qoq, adding more than $0.07/share to earnings relative to the Street. While a 65.9% efficiency ratio isn’t all that great relative to what I’d consider Texas Capital’s peer group, the bank is making progress and also reinvesting in that transformation plan.

Pre-provision profits rose about 29% yoy and more than 12% qoq, beating by about $0.16/share. Provisioning expense was much higher, though, almost tripling from the third quarter and driving $0.34/share of downside. A lower tax rate and other items helped limit the per-share damage to an $0.11/share core miss.

A Lot Is Going On With The Balance Sheet, And Most Of It Is Better For The Future

At first glance there are a lot of things to be concerned about looking at Texas Capital’s balance sheet this quarter. Loans dropped almost 16% qoq, deposits dropped nearly 7% qoq, and non-interest-bearing deposits fell more than 16%, while interest-bearing deposit costs are approaching 3%. Likewise, credit metrics aren’t exactly pretty.

I think it’s worth remembering that there’s meaningful restructuring going on here. Management is actively working away from the high-beta deposits that used to fund the balance sheet and has been moving away from certain areas of lending (like energy, leveraged lending, and mortgage finance) in favor of a stronger, arguably more traditional, core commercial lending franchise focused on C&I and CRE lending, while still participating in areas like franchise finance and healthcare.

Still, it takes time to rebuild a business. C&I lending growth was modest this quarter (up about 1% qoq), while real estate lending was stronger (up 4%). Mortgage finance loans declined 19% sequentially.

Looking at deposits, period-end balances came in about 8% lower than Street expectations, though the ratio of non-interest-bearing deposits to total deposits (42%) is pretty good. Deposit costs continue to ramp up, with interest-bearing deposit costs up 250bp yoy and 109bp qoq to 2.89%, the steepest increase I’ve seen this quarter, and total deposit costs have risen 135bp yoy and 60bp qoq to 1.54%. Not surprisingly, Texas Capital’s cumulative deposit beta is now on the high end of the range as it moves through the 30%’s, and I do have concerns that it could top management’s full-cycle target of 50%.

Credit is also a concern. While the ratio of non-performing loans to total loans isn’t too bad at this point (0.25% versus 0.16% in the third quarter), the 30% sequential increase in non-performing loans is still concerning, as is the growth in criticized loans (up 6% to 2.7% of the total). Meanwhile, charge-offs are accelerating, with ex-mortgage finance charge-offs up 34bp from 0.06% in the third quarter to 0.40%.

If I understand management correctly, a lot of this is from legacy loans. That doesn’t make it hurt all that much less, but I think it does reinforce why management has shifted the strategic direction of the bank.

The Outlook

I’ve seen bearish analysts sniffing that management’s guidance for mid-teens revenue growth in 2023 isn’t that much better than other mid-caps that haven’t been going through such strategic repositions. While true, I think it overlooks and ignores where the bank would be if management hadn’t made those changes and perhaps punishes them for the sins of past management decisions as bad deposits and bad loans get worked out of the mix.

If Texas Capital can hit their targets, pre-provision growth in the low-20%’s next year will compare quite well to many peer banks (and even “only” mid-teens PPOP growth would be pretty good). I do expect a more challenging outlook for FY’24, and my EPS estimate is about $0.50 below the current sell-side average (though also still well ahead of the Street low).

I continue to believe that Texas Capital’s plan can drive low-to-mid-teens core earnings growth over the longer term. That’s a bullish set of projections, no question, but I think the market and the strategic plan make it at least plausible. I don’t think ROTCE-driven P/TBV is a particularly useful valuation tool now, given how much of the Texas Capital story revolves around multi-year growth, but discounted core earnings and P/E approaches support a mid-$60’s fair value.

The Bottom Line

There’s quite a split on the outlook and qualities of Texas Capital; bearish analysts have fair values in the mid-$50’s or lower, while the most bullish analyst is at $80. I remain bullish on the long-term strategy and potential here, but I do admit that valuation doesn’t really allow for missteps, and there are still more challenges for management to surmount (including shifting an asset-sensitive balance sheet toward a more neutral position before rates start falling). While I’m neutral for now, a sell-off would quickly change that and this is a name for longer-term investors to keep on their watchlists.

For further details see: