2023-08-01 19:14:38 ET
Summary
- Washington Trust still sells at a discount.
- Despite a higher payout ratio than normal, WASH will continue to manage its costs and maintain its dividend.
- Unrealized losses in debt securities should never be realized. There should be no run on deposits as WASH is not Silicon Valley Bank.
- The Fed has established loans at par for debt securities that show unrealized losses which provides stability for Wash.
I think Washington Trust ( WASH ) is a good buy at these levels.
This year has been a wild one for regional banks. The bankruptcy of Silicon Valley Bank showed how U.S. banks were vulnerable to unrealized losses on debt securities. The Fed created a program to mitigate these risks, but people still have concerns. The uncertainty regarding the economy and banks in general created an opportunity for savvy investors. I was personally buying shares between $22 and $25 and believed the fair value for WASH to be between $40 and $50.
I arrived at this fair value by considering the historical trading PE's, the historical yields and the future projected earnings. I also took into account the reputation of the management and capital requirements of the bank. Since the market typically looks forward, it is important to consider not just where the company is this year but also where the company will be a year from now. The main reason for my current valuation is that I believe that this year is an aberration. By next year WASH will be back to operating as usual and earnings will return to a 2020 level.
One of the other main ideas that I took into consideration is that this is primarily considered a safe dividend stock. This means that one of the primary drivers of WASH's intrinsic value is the actual dividend. As long as the dividend is safe I expect the yield to be around 5%. Any drop in the current price will just elevate the dividend yield which should bring buyers and keep the price propped up. I do not believe that the dividend is in any danger so I believe that taking the current dividend of $2.24 and multiplying by 20 gives us a good minimum value to work from. By doing this we arrive at a value of $44.80. As a target, we believe this is extremely fair. Giving a 10% cushion in either direction is not the most elegant way to value a stock but puts us approximately between $40 and $50.
If you are valuing this stock purely off of earnings, and not considering any of the factors we mention above, a fair value range to $30 to $40 could be expected instead. This however is part of the art of determining intrinsic value. We believe just looking at current earnings is an incorrect method to valuing WASH.
This means I believe that ( WASH ) is still over 25% discounted to its intrinsic value making it a solid buy. Plus you get a 7% dividend while you wait but more on that later.
Revenue and Earnings
Revenue and Earnings (Seeking Alpha)
Washington Trust has been pretty steady in earnings since 2018 but has experienced a recent drop. Earnings per share dropped below the 2018 level for the first time in five years. Although this is a concern, we do not believe it is a danger. The next quarter might also be weak but 2024 estimates show a return to growth is on the horizon. I think this makes WASH an ideal candidate to average down into on any downside since a rebound is likely to occur regardless of economic conditions.
Earnings Estimates (Seeking Alpha)
Earnings might suffer a slight draw down in 2023 but should rebound throughout 2024.
Historically, WASH has been able to accurately predict earnings and growth due to the conservative nature of their management. This causes me to be confident in management’s statements.
WASH is still growing. During the recent Earnings Call found here, Ned Handy mentioned their commitment to continued growth and expansion,
“We are proud to report that our most recently added branches in East Greenwich, Cumberland and Barrington, Rhode Island, have reached approximately $70 million, $30 million and $8 million in deposits respectively. They have been open for 27 months, 11 months and 13 weeks respectively. We have two additional branches in process in the only ville section of Providence and in Smithfield, Rhode Island.
Stronger market conditions enabled improvements in both wealth and mortgage revenues. Wealth assets under administration reached $6.4 billion at quarter end, up by 3% driven by market appreciation offset by a normalized level of asset outflows. In our retail lending division, a concerted effort to increase loan sales drove a solid increase in gains in the quarter.”
These additional branches will continue to add to profits and assets in the future. The bank also recently eclipsed $7 billion in assets for the first time. Despite the decline in revenue, Washington Trust is poised to continue its growth and return to more historic rates of return on assets.
This drop in revenue does I think present a potential short term risk and leads us to the elephant in the room.
The Dividend
The increase in payout ratio and the high yield has scared some investors. Any dividend cut would immediately cause a precipitous drop in share price. I believe the fear is overstated because Washington Trust will not cut its dividend at any time in the near future. This is debateable though and not everyone shares my opinion.
I recently read, “ Washington Trust: Risks Appear Priced In, But Beware The Dividend Yield ” by Stephen Nemo and was shocked. His article explains in detail how unrealized losses in debt securities will lead to a cut in the dividend. If you want to see more of his explanation feel free to read his article linked above. As an owner of shares, I was concerned. I wondered if I missed something.
Everything Stephen says makes sense but, in my opinion, the whole premise of the article is flawed because it is based on a flawed assumption. The assumption that these losses will become actual losses in the future instead of unrealized losses. I felt I had a duty to go on the record and clarify what I see going on.
These paper losses should never be realized unless the underlying debt securities must be sold early. The only reason I think that this would occur is because the bank had a serious run on deposits and needed to raise cash quickly. This is what occurred at Silicon Valley Bank ( SVB ) leading to its bankruptcy.
But this can’t happen to Washington Trust because since the SVB debacle, the Fed set up a new borrowing facility, the Bank Term Funding Program (BTFP) offering loans of up to one year in length to banks, savings associations, credit unions and other eligible depository institutions, pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. The assets will be valued at par, so that banks won’t have to sell U.S. treasuries at a loss in order to redeem deposits as was the case for SVB. According to the FDIC, banks had about $600bn in unrealized losses on U.S. Treasuries and MBS at the end of 2022. The Fed would be taking on securities that have lost value as interest rates have gone up, but the Fed doesn’t have to mark-to-market. In the event a bank does not repay its loans to the Fed, the Fed could hold the collateral to maturity, when it would be redeemed at par. The Treasury has guaranteed $25bn in lending through the BTFP using the Exchange Stabilization Fund.
So in my view even if the Washington Trust needs to raise capital all it needs to do is borrow from the Fed using the debt security as collateral. The Fed will value the security at par and the crisis will be averted. Washington Trust will never have to sell the debt at a loss. The unrealized loss therefore will never be realized.
The recent one year chart is ugly primarily due to the scare caused by Silicon Valley Bank going bankrupt. We can see how WASH lost 40% of its value. This is what has caused the yield to be so high.
The dividend hasn’t been cut and I don’t believe it will be because Washington Trust is one of the most conservative banks out there. Their dividend history speaks for itself.
Dividend History (Seeking Alpha)
Washington Trust has raised its dividend consistently for almost three decades. The current payout ratio is currently at 64% which is seemingly well covered. The bank held its dividend steady during the 2009 banking crisis even when the payout ratio went over 80%.
In the very recent earnings call from July 2023, they were asked about the payout ratio and the upcoming dividend. I have highlighted the exchange below.
Earnings Transcript (Seeking Alpha)
If Ron Ohsberg goes on record, I tend to believe what he says. I think anyone that believes the dividend is not safe needs to take a closer look at the facts. When a bank with the reputation of Washington Trust tells you the dividend is safe, I think it is safe to trust them. They have been in worse situations before without cutting the dividend. The great thing about being one of the most conservative banks is that you can deal with these types of situations. My conclusion remains that WASH will not cut its dividend and will continue to grow. The share price will eventually return to its pre-crisis price above $50.
Risks
I understand that high dividends are usually a sign of danger. I even wrote an article recently about Chimera ( CIM ), a company that habitually cuts their dividend. You can read that article about Chimera here , but in the case of Washington Trust, I think the dividend being cut just isn’t a real risk. I am not saying it could never happen. I am only saying that it is not happening anytime soon in my opinion.
There are risks though because Washington Trust is more exposed to the local economic conditions in Rhode Island. Economic downturns or downturns in specific industries within that region could lead to higher default rates on loans, impacting the bank's profitability and asset quality. Washington Trust is susceptible to regional economic shocks or changes in local regulations. As a relatively smaller regional bank, WASH may lack the same scale and resources as larger national or international banks, which could hinder their ability to compete and adopt technological advancements, potentially affecting their growth and customer retention. Regulatory changes and compliance requirements specific to the regions it operates in could create additional costs and complexities. Investors should also be aware of the inherent risks that all banks face. As with any investment, I believe it is essential for investors to conduct thorough research and due diligence to understand the specific risks associated with individual regional banks and make informed investment decisions.
Conclusion
Despite concerns over the high yield and payout ratio, Washington Trust’s dividend seems safe. If they maintain the dividend, I expect the WASH shares to return to a price reflective of its dividend. This would also cause a return to a share price above $50 within a few years. At that point, we believe the yield will drop to a historic norm.
Washington Trust appears to be a compelling investment opportunity, not as attractive as it was around $22 but still a compelling discount compared to its intrinsic value of between $40 and $50. While the stock has seen some volatility due to concerns about unrealized losses on debt securities faced by U.S. banks, the Federal Reserve's Bank Term Funding Program (BTFP) provides a safety net for Washington Trust, reducing the risk of selling securities at a loss during times of crisis. As a conservative bank with a long history of accurately predicting earnings and a commitment to continued growth, WASH seems well-positioned to rebound from the recent dip in revenue.
The dividend payout ratio, though increased, seems manageable at 64%, and Washington Trust's history of raising dividends for nearly three decades instills confidence in its conservative financial approach. The recent statements from the bank's management further affirm the safety of the dividend. While the bank's exposure to regional economic conditions in Rhode Island presents some risks, and banks always carry certain risks, Washington Trust has proven the ability to weather economic downturns in the past suggests that it can navigate challenges successfully.
In light of these factors, WASH still appears to be undervalued compared to its intrinsic value, making it a solid buy with potential for growth. Additionally, the 7% dividend yield provides an attractive income stream while waiting for the share price to return to its pre-crisis level above $50. As with any investment, it is crucial for investors to perform due diligence and consider their own risk tolerance and financial goals before making a decision. Overall, Washington Trust presents a compelling investment opportunity that savvy investors might want to consider adding to their portfolio.
For further details see:
Washington Trust: No Future Dividend Cuts Likely