ZION - Webster Financial: Still A 'Show Me Story' But Likely Undervalued

2023-10-25 00:29:17 ET

Summary

• Webster Financial's third quarter earnings were solidly positive, with a 3% beat in pre-provision profits and NIM improvement on a smaller balance sheet.
• Management has been actively working down higher-risk lending lines, but the bank's exposure to leveraged lending is still a watch item, as is the funding mix.
• Finding undervalued bank stocks is not hard today, but Webster has a chance to become a significant commercial lending player in the Northeast and disrupt the market.
• Webster shares look undervalued below the $50's provided that mid-single-digit core earnings growth and manageable credit losses are accurate expectations.

Such is the skepticism and poor sentiment around banks now that finding a bank stock that looks undervalued basically just means that you found a bank stock. That’s not to say that there aren’t degrees of undervaluation or better/worse stories (and/or higher/lower risks), but the baseline bank stock is looking around 20%-30% undervalued relative to historical metrics unless expectations for 2024-2025 are meaningfully too high.

This brings me to Webster Financial ( WBS ), shares of which have basically tracked regional banks lower since my last update . Yes, this is another bank stock that looks undervalued, but it’s also one with a more interesting set of drivers than most, but also its own set of risks. I like the leverage to sponsor and specialty finance (as well as leasing and asset-backed lending), and I like the idea that management is building a franchise similar to Comerica ( CMA ) or Zions ( ZION ) in the Northeast. What I don’t like, though, is the funding pressure and the potential risk of CRE and C&I losses.

A Comparatively Good Set Of Results

Webster’s third quarter earnings look like they’ll go down firmly on the “good” side of the ledger; not the best I’ve seen, but certainly further to that side of the ledger. Moreover, guidance was pretty positive with respect to Q4 drivers that concerned me a bit in Q3 results (spread and loan growth, namely).

Revenue rose more than 2% year over year and declined about 1% quarter over quarter, beating expectations by almost $0.02/share. Net interest income rose more than 7% yoy and about 1% qoq, beating by close to $0.04/share. Net interest margin expanded 14bp qoq to 3.49%, beating by a couple of basis points, while earning assets declined more than 4% and missed by about 2%. To do that well on spread with a smaller balance sheet is impressive to me.

Non-interest income rose 1% qoq, missing by more than $0.02/share.

Operating expenses rose 3% yoy and fell about 1% on my preferred definition of core (that includes amortization expense). Normalizing to what most sell-side analysts do, the percentage changes were basically the same, but Webster beat by around $0.04/share. Pre-provision profits rose about 2% qoq and on a like-for-like basis relative to the Street, Webster beat by $0.06/share at this level.

Provisioning was lower than expected (adding another $0.04/share), but taxes were higher than expected and that took out around $0.02/share relative to sell-side estimates. Tangible book per share rose more than 6% yoy and declined less than 1% qoq to $29.48. Webster is fine on regulatory capital (a CET1 ratio of 11.2%), but I would like to see a higher tangible common equity ratio (7.2%).

Actively Managing Risk Through The Balance Sheet

Loan growth was not impressive at first glance, with end-of-period loans down 3% sequentially and about four points weaker than the banking sector as a whole. The key “but”, though, is that management actively chose to manage down risk this quarter, pulling back on mortgage warehouse, office CRE, equipment finance, and asset-backed lending. I’m fine with that, but the minimal sequential growth in sponsor & specialty lending was disappointing in the context that this is supposed to be an important driver and a “crown jewel” of the company.

Even with the de-risking efforts, earning asset yields are fine. Average loan yield improved 14bp qoq to 6.2% and the cumulative loan yield is a respectable 44%, while average earning asset yield improved 17bp to 5.49% (the beta is about 42% here).

Looking at credit, nothing jumps out as too concerning. Charge-offs did shoot up (up 45% qoq), but 0.23% isn’t a terribly high percentage at this point. Non-performing loan and asset balances declined about 2% sequentially. Classified commercial loans increased 20% qoq (to 1.7%), driven by healthcare and ABL, but management isn’t expecting much in the way of losses here.

Office CRE sits at a little over 2%, which isn’t ideal but is far from high compared to many comparable banks. A lot of this portfolio is your classic central business office (55% urban and 23% in New York City), and the credit metrics are showing stress (criticized loans at 5.6%, charge-offs at 2.8%), but I don’t think this business is large enough to do too much damage.

If anything, I’m more concerned about the bank’s skew toward syndicated loans (12% of loans are shared national credits) and leveraged loans (a mid-single-digit percentage). I think the CRE office risks are well-understood at this point, but leveraged C&I lending could be more problematic from a credit perspective in 2024 and 2025 than the Street realizes.

Funding Needs Work, But It’ll Be A Long-Term Project

Webster’s funding isn’t as strong as I’d like. Non-interest-bearing deposits held up well (down about 18% yoy and up 2%) compared to what most other banks are reporting (down 20%+ yoy and down mid-single-digits or worse qoq), but they only make up around 19% of deposits when most peers are solidly in the high-20%’s to low-30%’s.

Likewise, HSA deposits are no longer as much of a help as they once were. Post-merger, these low-cost deposits (0.15%) are only around 14% of the deposit mix and only grew 0.3% qoq – and I don’t think that the company can drive a lot of growth here without M&A. With that, the bank is having to turn more to expensive external financing. InterLink deposits grew more than 20% qoq (to 9% of the total) and came at a cost of over 5.4%.

Overall deposit costs are still pretty good on balance (a total cost below 2% and an interest-bearing cost of 2.4% is better than average), and deposit beta now sits at 46%, close to average, but this is a watch item for the coming quarters.

The Outlook

It won’t likely happen in the next quarter or two, but I do believe that the sponsor and specialty lending lines will bounce back in time and remain a source of growth. I also expect the company to leverage its scale to rely less on syndicated lending or at least be the lead on more of those loans. I would like to see service quality improve, though, as the real value in banking is establishing long-standing customer relationships where customers not only come back for loans, but transfer deposits to your institution and use a wider array of fee-generating services.

I’m looking for a mid-single-digit decline in core earnings next year, and that may prove too conservative given the recent performance with spreads and the possibility of outperformance on balance sheet growth. On the other hand, credit may take a bigger bite out of earnings later in 2024 than the Street expects. Long term, I’m still looking for around 4% to 5% core earnings growth.

Between discounted core earnings and margin-driven multiples, I think Webster is more undervalued than the average bank stock. Discounted core earnings give me a fair value in the low $50’s, while 10x my 2024 EPS estimate (a 20% discount to the historical normal forward multiple for similarly-sized banks) gets me to almost $60. Likewise, an 18% ROTCE in ‘24/’25 would support a 2.2x multiple of tangible book versus today’s 1.3x.

The Bottom Line

I think the funding issue is in hand, and I likewise think management is on top of the office CRE portfolio. I do think higher reserves and losses are likely (particularly as new, lower appraisals roll in), but I see more risk in the leveraged C&I loans, or at perhaps less-appreciated risk. I do also think, though, that Webster can grow pre-provision profits across the next three years and generate/show positive operating leverage – something not all banks will achieve and that should be rewarded by the Street in time.

Investors are spoiled for choice with undervalued banks, and I can appreciate that the Northeast is maybe not the most attractive region. Even so, I don’t think the “surplus undervaluation” here is entirely warranted, and this remains an attractive name at this price.

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