2023-06-07 07:00:00 ET
Summary
- NewtekOne Inc.'s unique business model once earned it the highest premium to net asset value of any business development company.
- It also grew its distribution quicker than any BDC I've covered.
- But that all changed when the firm announced intentions to convert to a bank.
- For those that understood Newtek well, it made sense. For those that didn't, or preferred BDC levels of income, it was a negative.
- Newtek has gone from an income investor's darling to an outcast. But is that justified? Let's review Newtek's first quarter as a bank to find out.
This article was published at iREIT™ on Alpha on Sunday June 4, 2023. This article was cowritten by Williams Equity Research.
Many Moving Parts
In our January article , I noted NewtekOne Inc. ( NEWT ) had just announced the completion of its acquisition of National Bank of New York City ("NBNYC"). The bank is 59 years old and nationwide. The combined entity is now known as NewtekOne.
In Q4 of 2022, Newtek received approval from the Office of Comptroller of Currency ("OCC").
We wrote about the proposed conversion shortly after it was announced. The article received 150 comments.
Why?
Investors were concerned. And it's obvious why.
Today, NEWT trades for $13-$13.50 per share . That's a long way from its 2021 highs near $40. During that time period, several key transitions were happening.
First, the shareholder base was rotating away from a concentration in income-oriented retail investors . Management was transparent that the business model would be changing, and that meant a sharp reduction in the dividend. A more diversified group of investors would take time to replace them. On May 24th of this year, NEWT was added to the Russell 3000 index.
Second, NewtekOne went "live" in the middle of the regional banking crisis. There was immense uncertainty as to how Newtek's bank would perform. Would they lose deposits like many smaller banks?
Is the value Newtek paid during a stable environment now far too rich?
Would the proposed integration and synergies come to fruition?
We'll tackle all of those in this article.
Thirdly, investors found it difficult to predict how cash flow and growth would look once the bank conversion and integration was finalized . Q1 2023 , which was reported recently, is our first opportunity to answer these critical questions. This wasn't made any easier by much larger banks failing left and right.
Let's evaluate NewtekOne's first quarter as a combined entity and see what clarity it provides.
Navigating A Tough Environment
NewtekOne's Q1 press release and management commentary didn't indicate it was suffering from any of the issues that sunk Silicon Valley Bank and Signature Financial.
Let's critically analyze NewtekOne's business for ourselves and see if we come to the same conclusion.
To start, 95% of NewtekOne's customer deposits are FDIC insured. Banks with a lower percentage of FDIC insured deposits are those at heightened risks for a bank run. Since NewtekOne focuses on small businesses and individuals, it diversifies its deposits across a large number of clients. Given almost all of NewtekOne's customers are at no risk of losing money if the bank were to fail, the probability of a bank run is extremely low.
In addition, NewtekOne does a good job of matching its liabilities and assets. You may recall me writing about this when discussing BDCs. I'll spend a minute on this subject since it's both important and confusing.
Say a bank invests client deposits in long-term treasuries yielding 3%. They believe this is the "safe" route. Unexpectedly, short-term rates rise from 0% to 5%. In order to keep customer deposits from fleeing to other banks, they need to pay customers a lot more interest on their checking and savings accounts.
If they don't, customers are likely to withdraw their money. If they do, the bank is eventually forced to sell those 3% bonds. The problem is the duration of those bonds is different than that of the deposits. The bonds have a higher duration, meaning they are more sensitive to changes in interest rates.
Their value goes down sharply when interest rates rise (and vice versa). If this goes too far, the bank becomes insolvent. In a nutshell, this is what happened at Silicon Valley Bank and others.
To avoid this, companies can match asset and liabilities. Any company that borrows money to lend money must manage this carefully (customer deposits are liabilities on a bank's balance sheet, not assets).
In NewtekOne's case, it encourages depositors to invest in CDs with terms of two years or less. As long as the investments NewtekOne makes with these funds have a similar liquidity/duration profile, it will be in good shape no matter what interest rates do.
Another key source of capital is its high yield savings account. With no fees and no minimum deposit. Let's see how it stacks up to other banks.
These are the top ranked high yield savings accounts on NerdWallet.
Bankrate's list is exactly the same. The highest yielding is CIT Bank at 4.85%, and it requires a $5,000 deposit to achieve that rate.
I looked around, and NewtekOne has the best high yield savings account I could find. Its CD rates are not quite as competitive at 40-60 basis points below the best available.
Now that we have a good grasp on the bank's positioning, what's happened with deposits?
The bank division saw a 121% increase in deposits from the end of 2023 through April 28, 2023. Gathering an additional $170 million in customer deposits during a banking crisis was way above my expectations. Personally, I would have been satisfied if management was able to maintain end-of-year levels given so many customers fled smaller banks.
The source of those deposits was interesting as well.
$115 million or 68% were derived from the new digital account opening platform. Newtek was always as much a technology company as it was a BDC. It's no surprise that Newtek was able to improve and modernize the bank's digital and marketing capabilities.
In April, NewtekOne's bank began funding its SBA 7(a) loan origination pipeline and its SBA 504 and Commercial & Industrial ("C&I") loans. Previously, Newtek Small Business Finance, LLC ("NSBF" in the company's filings), and nonbank lender, funded the loans.
As you might imagine, banks have advantages when it comes to lending compared to nonbank lenders. Only banks, for example, can accept public deposits. That's far cheaper than any other source Newtek previously had.
Risk & Portfolio
This shows the type of loans on the balance sheet .
Loans with on-time payments (performing without any issues) have grown from 2,651/$378.4 million as of Q1 2022 to 3,442/$459.6 million as of Q1 2023. Note that ~97% were current a year ago and ~96% are today.
Compared to the ~3,500 loans current on payments, 62 are 31-60 days late and 17 are 61-90 days late.
NewtekOne's main risk is loan investments underperforming. That is best measured through the non-accrual rate. Most bank and nonbank lenders have seen an increase in the non-accrual rate since the end of 2022.
That's not the case for NewtekOne .
But how do we know these levels aren't problematic? Maybe the non-accrual rate was much lower in prior years? The SEC filings provide firm-wide statistics over time.
It was 13.8% at the end of 2018, 13.2% at the end of 2020, 12.5% at the end of 2021, and 13.1% as of the end of 2022. That's certainly consistent.
For Q1 2023 specifically, there were $42.4 million of loans on non-accrual. $39.8 million (~94%) were SBA 7(a) loans, which makes sense given that's NewtekOne's focus.
As of December 31, 2022, there were $34.4 million of SBA 7(a) loans on non-accrual. That's a ~$5 million increase on a $580 million loan portfolio that also grew in size over the period.
SBA loans require personal guarantees and the underwriting guidelines come from the SBA . They are not "adjusted" internally by the lender to hit quotas. The rate is also set by the SBA, and not the bank. NewtekOne's business model is to originate, aggregate, and sell these loans. We'll discuss that in more detail in the next section.
In addition, the company raised $70 million in capital by selling $50 million in senior financial holding company debt and $20 million in convertible preferred shares. These came with an 8% yield . This is a smart strategy because the 8% preferred stock will never cost more than 8% in annual interest expense.
If the government prints another few trillion dollars, the Fed may have to raise rates even higher than expected. NewtekOne wants to hedge against that risk by funding part of its capital structure with preferred and senior debt that won't become more expensive if rates rise.
Cash Flow & Dividend
Net premiums dipped a little in 2022 but recovered to 2020 levels in Q1 2023. SBA loans are set off a floating benchmark, so that allows firms like NewtekOne to maintain consistent margins. This is an important concept, so let's take a look at how it works.
Interest expense was exceedingly consistent at $1.7-$2 million quarterly in 2021 and the first half of 2022. That changed dramatically as interest rates increased. We see that in the above chart with Q1 2023's interest expense coming in at $6.7 million compared. At the same time, interest income of $13.2 million was double previous quarters.
Net interest income, which is the interest income minus interest expense, rose from $4.2-$5.2 million in previous quarters to $6.6 million in Q1 2023.
There are a few things to consider on this topic.
The bank was integrated during Q1 2023. We only have one quarter of data at our disposal. It also achieved massive (>120%) growth in deposits last quarter.
That's a lot of moving parts.
If current trends continue, 2024 has a ton of potential . At the same time, there is no guarantee that'll happen. While NewtekOne should be able to achieve favorable returns on its 4-5% cost of deposit capital (CDs and savings accounts), we can't look back several quarters to confirm that. Both the current interest rate environment and NewtekOne's business model have changed dramatically in recent quarters.
For now at least, things are operationally pointing squarely in the right direction.
Let's talk earnings.
NewtekOne is best measured using traditional earnings per share ("EPS"), which is a plus for investors. It's easier to understand and it's a GAAP number. That means it's the same basic calculation for every company.
To start, NewtekOne exceeded its Q1 2023 EPS forecast. It also beat analysts' consensus. The fact that occurred during the heart of the banking storm is no small feat.
With Q1 2023 in the books, guidance of $1.70-$2.00 per share looks very reasonable. Given the $0.18 quarterly dividend (note: do not rely on Seeking Alpha's figures, they are trailing twelve month and not an accurate reflection of future payments), that's a 39% EPS payout ratio using the midpoint of 2023 guidance. That's in line with bank sector norms of ~35%.
The $0.72 annual dividend equates to a 5.5% dividend yield at $13 per share. That compares to the iShares U.S. Regional Banks ETF ( IAT )'s 4.2% yield and iShares U.S. Financials ETF ( IYF )'s 1.9%.
Valuation
I want to start off with a couple data points I don't think many NEWT investors are aware of.
This is a 1-year chart of NEWT. It's the dark blue line. Notice how closely it mirrors the other line since the start of this year?
It's almost identical.
That's the iShares U.S. Regional Bank ETF . The ETF is down 33% in the past six months. NEWT is down 28%. We can never say precisely why a stock goes up or down outside of the supply and demand for shares. That said, it certainly appears the NEWT's membership in the banking community has been a major contributing factor to its share price decline in recent quarters .
If that's true, than NEWT should recover alongside its banking peers whenever that eventually occurs. If it's able to post blowout numbers in the interim, that could change. Let's move back to our regularly scheduled valuation program.
Neither NewtekOne nor its predecessor were the easiest to value.
As a business development company, or BDC, at least the market could use the distribution and payout ratio to get a ballpark figure. Even then, the market generally awarded NEWT higher premium to net asset value ("NAV") than all its BDC peers. Investors recognized Newtek was special.
In its new bank holding company form, these options no longer apply.
Banks are often valued based on different types of book values. Tangible book value was $7.77 per share as of the end of Q1 2023. Common book value was lower at $6.96. These figures have limited use as well.
Since NewtekOne is no longer a registered investment company (often called a "RIC" by the industry), it had to change the carrying value of parts of its business. All the "asset light" portfolio companies were removed completely and replaced with negative $2 million in tangible book value.
Since that's obscure, I'll illustrate that that means with real numbers. Newtek Merchant Solutions, Newtek Technology Solutions, Newtek Insurance Agency, and Newtek Payroll Solutions were previously valued at $166.7 million. These are the "asset light" portfolio companies I mentioned previously.
After converting away from a RIC, those entities now detract $2 million from tangible book value.
While we'll never ignore book value, given that NewtekOne generates consistent GAAP earnings per share, that's likely the best single way to value the company.
EPS for 2023 is on track for $1.70 to $2.00. At the midpoint of $1.85, that's a 7x multiple. This year matters, but stocks are forward looking. If they weren't, no company without positive earnings would be worth a dime (much less tens of billions of dollars).
Management is guiding for $2.80-$3.20 in EPS for 2024 . That's 62% growth year-over-year, which is among the most rapid of any company we follow.
What conditions need to be met to make that feasible?
As Q2 and Q3 figures are released, we need to see a few things to make that realistic.
Non-accruals need to remain under control . Net realized premiums need to remain similar as well.
While we don't need as rapid increase in deposits as witnessed in Q1, the bank portion of the business needs to continue growing throughout the year. If Q2-Q4's growth rate is even 50% of Q1's, I think NewtekOne will achieve that objective.
Lastly, the whole NewtekOne system needs to work together to keep increasing originations.
If the firm can do that, 50-60% earnings growth in 2024 isn't unrealistic. If we see one or more of these key variables falter in 2023, we'll reduce expectations for 2024 accordingly.
Let's say that 2024's growth is half of what management expected. And management's historical guidance has been more accurate than most compares for whatever that's worth. That's $2.42 in 2024 EPS, or 5.4x multiple. Don't forget that's for a company growing GAAP EPS at 30-35%.
I don't think that'll hold.
The stock would have to rise to at least $19-$21 per share, otherwise a private equity firm or larger peer will buy NewtekOne for its SBA infrastructure and experience at that valuation.
If management is able to achieve the lower end of 2024 guidance, the 5.4x drops to 4.6x and the stock price moves to $23-$25. Keep in mind a lot of the concern with NewtekOne today is execution risk.
If management continues to execute, that'll dissipate and investors will have another tailwind. Remember, it wasn't that long ago that the same management team and essentially the same business model garnered extreme optimism (e.g., >2x premium to NAV as a BDC) from investors.
Low $20s as a late 2023/early 2024 price target is very reasonable in my view if management is able to achieve even half of their targets. Over a longer 1-2 year period, once again provided management continues to make progress, albeit not as extreme as Q1 2023's, high $20s or low $30s is very reasonable for the stock.
Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
NewtekOne: Critical Look At The Entity's First Quarter