2023-04-07 07:00:00 ET
Summary
- For many years, NewtekOne was a top-performing BDC. It delivered total returns easily surpassing the S&P 500.
- NewtekOne acquired a bank and just converted to a financial holding company. This article explains why that seemingly strange move makes a lot of sense.
- But the market, especially retail investors, did not like this change. Ever since that deal, NewtekOne stock has suffered. Resetting the dividend to bank norms didn't help.
- That said, and as we’ll show, management has done exactly what it stated it would do.
- The firm just announced an important update to its forecasts and targets for 2023. Let's analyze and update our thesis on battleground NewtekOne.
This article was written by Williams Equity Research.
Setting the Stage
NewtekOne ( NEWT ), formerly Newtek Business Services, has a history of changing structures as the opportunity set changes. The firm has been around for a long time and publicly traded since the year 2000.
In 2014, it transitioned to a Business Development Company ("BDC"). NewtekOne consistently achieved S&P 500-beating returns. To our knowledge, NewtekOne as a BDC increased its dividend faster than any peer over any period. To put this into context, since converting to a BDC, NEWT paid out approximately $330 million in dividends and distributions to investors. The current market cap of NewtekOne? $320 million. Long-term investors are "playing with the house's money" as the expression goes.
Other things made NewtekOne special. Many BDCs, even great ones, struggle to maintain a premium to net asset value ("NAV"). Without a premium, the BDC can't issue new shares economically and it hinders growth and the overall business model. NewtekOne easily earned a 1.5x to 2.0x premium to NAV. Only one other BDC, Main Street Capital ( MAIN ), was even in the same league. That's how much confidence the market had in NewtekOne.
Newtek's unique business model even allowed it to capitalize on PPP loans thanks to its pre-established network of small business customers. This gave its cash flow a major boost just when its peers were suffering the most.
NewtekOne also is internally managed. While standard for its current holding company structure, that's rare in the BDC space. It also has more insider ownership than most peers. Let's start with an update on that important topic.
Per Nasdaq , there have been zero insider sales in the past 12 months and 251,781 shares purchased. In March alone, there were nine insider buys of at least 1,000 shares. That doesn't include compensation for stock options. One director bought $493,290 worth of shares on March 23. Barry Sloane, the founder, CEO, and chairman of the board, owns approximately 5% of all shares outstanding. That's worth over $16 million, even at today's depressed share price.
Insider buying never supersedes fundamentals. But given how much management teams talk about how great things are going, there's something to be said when management walks the walk . That's especially the case when the market is losing confidence or confused about the company's future.
Q4 Earnings Review
NewtekOne Small Business Finance, LLC ("NSBF") is the small business lending arm of NewtekOne. NSBF funded a record $775.6 million in SBA 7(a) loans in 2021. The fact it was a rounding error from management's initial guidance of $775 million should tell you how well they know the business.
Not only that, but 2022's SBA 7(a) loan volumes exceeded 2021's by 38.4%. Q4 2022's $188.7 million in SBA 7(a) was down 4.7% compared to Q4 2021. Management guided for $875 million for 2023, another 12.8% increase compared to 2022's record performance.
Total investment income ("TII") was $23.1 million in Q4 2022. That's a 6.9% decrease compared to the same period in 2021. Adjusted net investment income ("ANII") of $1.5 million equates to $0.06 per share, which is a large decrease compared to the $16.0 million or $0.66 per share generated in Q4 2021.
The total investment portfolio grew by 6.5% year-over-year to $808 million at year end. Netwek's NAV decreased from $16.72 at the end of 2021 to $15.25 in Q4 2022.
So what's the deal with 2022 numbers compared to 2021? NewtekOne earned $50 million in fee income from PPP loans in 2021. We all knew it wasn't going to repeat in 2022, and management reiterated that many times, but I think the headline numbers still punished the stock over the past year.
It's a similar story with the dividend. In late February Newtek's board of directors declared an $0.18 quarterly dividend as the first payment as a financial holding company. The market panicked. In reality, management forecasted a $0.16 per share dividend.
Guidance within the Q4 earnings release was $1.70 to $2.00 in earnings per share ("EPS") for 2023 and $2.80 to $3.20 per share in 2024. This is a good place to mention a few things about analyzing NewtekOne going forward.
As a holding company, NewtekOne is no longer a regulated investment company ("RIC"). That's the classification of BDCs (and REITs) allowing it to avoid corporate taxation. Other elements, like NAV, also are no longer applicable. Accounting practices are different for a BDC and holding company, so it's no longer apples-to-apples.
Parts of Newtek's business previously counted toward its NAV. As a bank, its Merchant Solutions and Technology Solutions divisions, for example, won't contribute meaningfully to tangible book value. That's the NAV equivalent for a bank. On the Q4 conference call, the CEO stated he expects these assets to be worth approximately zero from an accounting perspective.
BDCs are limited to 2:1 leverage. NewtekOne can now go as high as 10:1. That greater return on equity won't happen overnight, but it will pay dividends over time. That's especially the case because NewtekOne focuses on higher margin loans instead of just residential consumer loans, home equity lines of credit, etc.
If BDC metrics are out the window, what should we look for? Traditional banking metrics. Return on average assets ("ROAA") should be 3%-4% and return on tangible common equity ("ROTCE") between 20-30%. Those are a good start.
JPMorgan ( JPM ) is considered the strongest and best run large bank in the U.S. It's ROAA? Less than 1% in the past three quarters . ROTCE? 15.33-16.08% in the past three quarters . NewtekOne is targeting far superior results straight out of the gate.
Now you understand the potential outperformance of Newtek's business model. Let's move on to the announcement just made by management on April 4.
Balance Sheet and Key Ratio Updates
The CEO recently released a detailed statement regarding key performance indicators for 2023. This is unusual given Q1 2023 earnings are scheduled to be released on May 3.
Typically, this occurs when management believes financial or operating performance is significantly above or below the market's expectations. Since NewtekOne converted to a bank in the middle of a banking crisis , it makes sense that management wants to provide clarity to investors.
I'll cover the important takeaways here. First, NewtekOne sold $50 million in two-year notes rated BBB+ (three notches into investment grade) by Egan Jones. That's the credit rating agency used by many smaller companies that can't justify the expense of using an S&P, Moody's, or Fitch. That's a positive development on its own, but the fixed interest rate on the unsecured private notes of 8.125% is even better. For context, BBB+ investment grade rated Ares Capital ( ARCC ), the largest and one of the best managed BDCs, currently has unsecured bonds trading with yields-to-maturity (YTM) just under 7%. $230 million market cap Newtek's cost of capital is only 1-1.5% greater than $9.8 billion market cap Ares Capital.
Tier 1 capital is the most common metric to gauge a bank's financial health and liquidity. Mr. Sloane stated the newly acquired bank division of the company had $78 million in Tier 1 capital as of Jan. 31. That's about 30% of total assets. The average for all U.S. banks was 14.25% at the end of 2022. It's been between 13.43% and 14.93% since Q1 2020.
Newtek's bank has twice as much Tier 1 capital as the current and long-term average for U.S. banks. Now, what about the issues that sunk Silicon Valley Bank? Is NewtekOne exposed to the same risks?
As a reminder, unrealized losses on long and medium-term Treasuries were a primary driver of the recent bank failures. As interest rates rapidly increased, the value of those fixed-rate "risk-free" bonds decreased. This created major problems for banks that received a high percentage of their deposits in 2020 and 2021 when interest rates were at their lowest. You guess it, like Silicon Valley Bank and Signature Bank.
NewtekOne, on the other hand, has a modest investment portfolio of $33 million compared to total assets of $250 million. $29.7 million, or 90%, of that investment portfolio has a maturity of one year or less. And they paid an average interest rate of 4.93%. What about the remaining $3.3 million? Those are government agency securities maturing in 19 months or less. This are the exact stats we want to see on this subject.
Another issue that cratered Silicon Valley Bank was the high percentage of assets not covered by FDIC insurance. That makes depositors nervous and incentivizes them to move their money elsewhere.
Since NewtekOne works with mostly run-of-the-mill small businesses, its average account balances aren't in the millions. Only 11% of total deposits were above the FDIC threshold. That compares to 93% for Silicon Valley Bank. Not even close.
During the first quarter of 2023, NewtekOne gained an additional $110 million of deposits. That's an incredible 78% increase when many small and medium-sized banks were losing deposits to larger banks like JPMorgan.
What does this mean for Newtek? It has near-zero interest rate risk and effectively no chance of falling into the same trap as Silicon Valley Bank and Signature Bank. It's also as well capitalized on a percentage basis as the best banks in the country.
To be clear, Newtek's business is different from the likes of JPMorgan. Whether one is riskier is debatable. They certainly have different risks. JPMorgan's balance sheet is an order of magnitude more complex. But it also has a much more fortified balance sheet and a larger percentage of what are perceived to be low-risk loans (mortgages weren't "low risk" in 2009). What really matters is the risk-adjusted return of the loan portfolio. In that department, and based on its already reported numbers, I think Newtek's is among the best of any bank.
Operational and Financial Updates
Firmwide, NewtekOne had a 12% increase in loan closings. Margins also improved from 108.72% to 110.84% in Q1. Mr. Sloane also stated "we have not experienced a discernable increase in non-accrual loans" since the end of 2022. It appears NewtekOne is reversing some of the momentum lost in Q4 2022.
As an investor in NewtekOne common stock or baby bonds, it's essential to understand the basics of Newtek's business. Newtek's loans are issued at Prime plus 3.0%. That's 11% at today's rates. This is important because that's a large spread even if NewtekOne must pay 5% on deposits.
Most banks focus on auto and home loans with 6%-7% interest rates. Newtek's spread is 300% greater than those loans generate. Since it can afford it, NewtekOne could gain even more deposits by simply offering a slightly higher interest rate on deposits than the competition. It would still enjoy greater margins than almost all its peers.
NewtekOne didn't buy and integrate a bank into its business model just to see how the stock market would react. For years, it has issued hundreds of millions in loans that end up going into a bank. Now, those clients can use Newtek's bank.
If even a modest portion of those loan customers become bank customers, Newtek's bank deposits will grow extremely rapidly. January's results suggest we are already seeing this occur.
Conclusion and Valuation
Mr. Sloane confirmed Q1 guidance of approximately $0.41 in after-tax earnings per share. Our independent assessment suggests that'll grow to at least $0.45 by year end or at least $1.72 annually per share. Management last guided for $1.70-$2.0 per share.
If current trends continue, $2.70 in EPS for 2024 is the minimum threshold we think NewtekOne can reach. That's assuming macroeconomic conditions deteriorate. Management is guiding for $2.80-$3.20 EPS. And as you may recall, their crystal ball is a lot better than most.
That puts today's stock price of ~$12.50 at 7.27 times the low-end of 2023's earnings. It falls to 5.63 times 2024's low end earnings estimate. Peer comparisons have never been easy with NewtekOne, and that hasn't changed.
One option is the Invesco S&P SmallCap Financials ETF ( PSCF ). I did the math, and its average P/E ratio is currently 12.0x. It was 13.73x at the end of 2022. Another is the iShares Regional Banks ETF ( IAT ). It trades with an average P/E multiple of 8.27 as of April 4.
But that doesn't tell the whole story. Some regional banks, including a couple of the largest, are trading at distressed valuations as their solvency is in question. First Republic Bank ( FRC ), for example, trades at a 1.8 P/E ratio. If we focus on higher quality regional banks, like Cullen/Frost Bankers ( CFR ), they trade for closer to 10 times earnings.
What can we conclude? From an earnings perspective, NewtekOne is going out of its way to remind the market that the business is strong. From a liquidity/balance sheet perspective, NewtekOne also is in a great position and is one of the better capitalized banks I've analyzed (and I've analyzed a lot lately). Lastly, its valuation is below both small cap financials and regional banking peers. The only banks you can find trading with lower multiples than NewtekOne are teeter-tottering on insolvency.
Don't forget, NewtekOne has better than average Tier 1 capital ratios and almost zero sensitivity to interest rates.
I consider NewtekOne highly attractive at current trading levels below $13 per share. Assuming a two-year hold, $21.60 per share is our low-end estimate (8 P/E multiple and $2.70 EPS in 2024) for an ~80% total return with $35.20 (11 P/E multiple and $3.20 EPS in 2024) on the high but still realistic end for a ~190% total return.
NewtekOne has a couple baby bonds outstanding under (NEWTL) and ( NEWTZ ). These are trading near par and yield around 5.9%. I think there are better fixed income opportunities out there and the risk-adjusted return potential of the common is far better than the baby bonds. This does tell us that the bond market is not the least bit worried about NewtekOne.
I'll close with one more example. If NewtekOne were to trade at the same earnings multiple as the small cap financial average at the end of 2022, it would be worth $41.19 per share (PSCF end of 2022 13.73 P/E multiple and midpoint $3 EPS in 2024) or a ~240% total return over a two-year hold. Either way, something's gotta give.
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:
Something's Gotta Give: A NewtekOne Update You Don't Want To Miss