VLY - Valley National Executing On Its Plan But At A Cost

Summary

• Valley National's fourth-quarter earnings basically met expectations, but there wasn't a lot to get excited about in terms of spreads or dramatic operating leverage improvement.
• Loan growth of close to 4% was definitely above-average, but so too was the sharp increase in deposit costs, as Valley is willingly chasing higher-cost funding to fuel its growth.
• I like the areas that Valley management is targeting for growth, and I like the deposit growth initiatives, but management is taking on some risk of being aggressive now.
• Valley National is close to a "buy" call for me; I see elevated funding risk in the short term and also above-average near-term and longer-term growth.

As I previewed back in December , Valley National ( VLY ) continues to drive above-average loan growth, particularly in the commercial real estate space, but is doing so in large part by relying upon high-cost funding. This creates an interesting stock dilemma over the next year or two - the Street values growth at banks (particularly revenue and tangible book value per share), but it also values margins, and I'll be very curious to see which wins out.

These shares have risen about 5% since my last update, roughly in line with its peer group. I do believe management has put this bank on a better path, including loan growth driven by organic expansion (to the extent that hiring away productive loan officers is "organic") and targeted efforts to grow sticky deposits. I expect above-average core earnings growth over the next five and 10 years, but it's less clear that margins will be meaningful superior to peers. I do think these shares remain undervalued, and I'm warming up to the strategy, but I do still see risks to the outlook from funding costs over at least another couple of quarters.

Lackluster Fourth Quarter Results Don't Show The Longer-Term Growth Benefits

Rebuilding Valley National in a way that will generate more growth is a multiyear project, so the fact that Valley's fourth quarter results didn't show that superior growth doesn't mean all that much to me. That said, it will take more than in-line results to get more investors excited about the opportunity here.

Revenue rose 2% from the prior quarter, modestly missing expectations (about $0.01/share). Net interest income rose almost 3% sequentially, but this was below expectations (by a little less than ($0.01/share), with net interest margin actually down 3bp to 3.57%, while earning assets grew almost 4%. Not all that many banks in Valley's peer group posted sequential NIM contraction ( First Republic ( FRC ), KeyCorp ( KEY ), SVB Financial ( SIVB ), and Signature ( SBNY ) were among them), and Valley is paying the price (literally) to aggressively grow its loan book.

Non-interest income isn't a big part of the revenue mix at this point (about 10%), but this line item declined about 5% quarter over quarter, missing by close to half a cent.

Operating expenses were up about 1% qoq, coming in about $0.01/share worse than expected. I should note, though, that many analysts do exclude amortization from their expenses and if I do that with this quarter's expense number, the result is basically in-line with expectations; I can't check every estimate to see if that what's the analyst did, but I think it's fair to say that Valley didn't beat on expenses but at worst missed only modestly, and the efficiency ratio (below 50% in either case) compares well to peers

Pre-provision profits rose about 3% this quarter, or around half the rate of what I'd consider comparable banks. Pre-provision profits missed by a penny or two, with lower provisioning expenses adding back some of the miss.

Above-Average Loan Growth... But At A Rising Cost

I'm not surprised that Valley's fourth quarter loan growth was better than average (up close to 4% versus around 2.5% for the average of its peer group), nor am I surprised that deposit costs were significantly higher. I laid out that story in that earlier article, and this is part of the plan that the company is following - paying the cost for growth today, with loans that will likely stay on the balance sheet for a while (and establishing potentially long-term lending relationships) and recognizing that deposit costs will eventually moderate.

Within the loan book, CRE lending was up about 5%, and that was well above the average for the period as many banks are actively backing away and reducing their exposure to CRE lending. That's creating new lending opportunities for Valley, but it's not unreasonable to wonder whether there could be a higher price to pay down the road for being aggressive when other lenders are being more cautious. Auto lending also stood out, particularly at a time when many lenders are backing away from this space too.

I wish Valley had a more robust C&I lending franchise, as I expect that to be a relatively stronger category in 2023. This is a work in progress, though, and I do think that C&I lending could accelerate some in 2023.

As for the cost side of the equation, deposits rose 5% sequentially, but non-interest-bearing deposits fell about 6%, while time deposits jumped 51%. Management said that about $900M of non-interest-bearing deposits rotated into interest-bearing accounts, and I would note again that management has been aggressive in paying up for deposits (the interest-bearing deposit cost rose 180bp yoy and 111bp qoq to 2.03%, near the top of the list for year-over-year increases), with some of the highest CD rates back in December.

I think there could be some longer-term benefits. First, I would argue it's better to keep your depositors with you, even if it's in higher-cost accounts. Second, by being aggressive early, I think Valley has captured some deposit share from less aggressive players, and I think there may be less incremental damage from here (take the pain early, rather than later, and maybe there will be less pain).

The loan beta is now at 34% (cumulative), and management expects it to reach 50% - probably a reasonable expectation, though I continue to see risk of overshoots across the banking sector. While efforts to grow new sources of lower-cost deposits (cannabis-related companies, homeowner associations, et al), are producing results, it will take time, and non-interest-bearing deposits will probably decline further from here (30% of deposits).

The Outlook

Only time will tell whether aggressively seeking loan growth at this point in the cycle will pay off. I think it will, and given that Valley used to rely more on M&A with questionable long-term value creation for growth, I'd rather see this risk rather than going back to the growth-by-M&A well.

In the meantime, management is looking to grow loans at a 7% to 9% rate in 2023. That's actually not that aggressive relative to its peer group, but what makes it aggressive is that with a loan/deposit ratio of 98%, the incremental cost of this growth will be higher than for many of those peers. I think it will pay off in time, particularly if the Fed is close to easing off its hawkish cycle, but it's a risk.

Even with funding cost risk, I think Valley National will grow pre-provision profits at a double-digit rate from 2022 to 2025 that should be at or near the top of its comp group. Also, unlike many banks, I don't expect a year-to-year dip along the way in either PPOP or core earnings. Longer term, the 6%-plus core growth I expect from Valley is also comfortably above average. This growth should come from focused branch-driven middle-market lending, as well as national specialty vertical/niche lending enabled by the Leumi acquisition.

Between long-term core growth of 6%-plus, a near-term ROTCE in the 16%'s, and a forward P/E of 10x on my '23 EPS estimate ($1.40), I believe Valley shares should trade somewhere around $13.50 to $16.

The Bottom Line

I admit to leaning pretty bullish on Valley at this point. I like the business plan, but I'm not completely convinced it's the right plan for this phase of the cycle, and I do see risks to spreads, margins, and expenses in the short term. I also see other bank stocks with bigger discounts to fair value that arguably don't have the execution risk. For now, then, this remains a borderline "buy" for me, and one that I think could rerate higher as a more accommodating Fed policy comes into view.

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