It’s been a while since I’ve written about Bank of the Ozarks (OZRK) for Seeking Alpha, in part because there’s a limit to how many different ways you can say “it’s a well-run, high-growth bank, but the multiple is rich”. In any case, the shares are a little under 20% from my last update (when I thought it was too pricey for me), and I’ve frankly done better with my positions in JPMorgan (JPM) and BB&T (BBT) over that same time.
I continue to find it difficult to get completely comfortable with the valuation on this bank, and I’m a little concerned about the aggressive pace of C&D lending at this point in the real estate cycle. Management’s skill in navigating past cycles has certainly earned them the benefit of the doubt with me, and I like the long-term potential of not only replicating the specialty lending model across the country but also diversifying the loan book and building up core deposits.
Growth, At A Price
Bank of the Ozarks continued to post strong growth metrics in the first quarter, but some of the costs of that growth also stood out.
Revenue rose 10% from the year-ago period on a 13% increase in net interest income. While the bank saw high teens growth in earning assets, spread compression (reported NIM down 19bp) was a notable headwind – particularly for a bank where the sell-side often likes to celebrate the heavy skew toward variable-rate lending on short-term indices (like one-month LIBOR). Fee income was down 11%, but still represents a small part of the revenue mix.
While many banks are still firmly committed to limiting their opex growth, Bank of the Ozarks is reinvesting in its business to support and drive growth, leading to 20% yoy expense growth in the first quarter and just single-digit pre-provision income growth.
So far this quarter one of the themes has been so-so loan growth for regional banks, but OZRK continues to excel here, as loans grew 12% yoy on a period-end basis. The roughly 4% sequential loan growth was also strong on a relative basis, with real estate lending growth lagging slightly (up 3%) as management continues to try to build the non-real estate book. Deposit growth basically matched loan growth, but the cost of deposits continues to rise, with the bank’s beta now over 40% since the rate hike cycle began (versus the low 30%’s for PNC Financial (PNC)).
Credit quality looks healthy, with steady provisioning and low levels of non-performing assets and charge-offs.
The Model Works, But Mind The Risks
Bank of the Ozarks has always run itself differently than most banks, and for the most part that has been to the advantage of its shareholders.
In particular, OZRK has prospered by focusing on construction and development (or C&D) lending – one of the riskiest categories of bank lending. Whereas the typical FDIC-insured bank has about 4% of its loan book in C&D lending, OZRK makes 43% of its loans in this category. It typically requires more due diligence (and risk appetite) to successfully underwrite C&D lending, and OZRK has built its Real Estate Specialties Group by hiring CPAs, MBAs, and lawyers with real estate experience. That has helped the company avoid major losses (there have been minimal charge-offs in the RESG since its founding), but high peak C&D losses back in 2009-2011 hammered many lenders. The compensation for that risk has been above-average yields, as seen in OZRK’s hard-to-match net interest margin of 4.7%.
OZRK has been aggressive in trying to build its business, expanding outside of its home market of Arkansas into Georgia, Texas, Florida, North Carolina, and New York (among others). With that, OZRK now gets about one-third of its deposits from the state of Arkansas (where it is the #2 bank by deposit share), one-quarter from the state of Georgia (where it is #9), and 16% and 13%, respectively from Florida and Texas. Interestingly, there’s still a lot of room for the company to backfill its branches with deposits – while the bank has around 4% branch share in its 150-plus served cities, it has less than 1.5% deposit share. Driving more core deposit growth through this branch network is an important item on the to-do list, as non-interest deposits are less than 20% of the deposit base and wholesale funding (large CDs) are almost 20%.
The risks in the C&D lending business are my biggest concern right now. I know OZRK focuses on asset quality (ahead of profitability and growth) in its RESG underwriting. Likewise, I know about the strong historical credit track record and its low reported loan-to-value and loan-to-cost metrics. Still, I am concerned about how aggressively OZRK is pursuing loan growth in markets like New York City (which is about one-third of the RESG loan book) where many banks are pulling back and where adverse selection may be becoming a bigger concern. Banks like JPMorgan, Bank of America (BAC), and Wells Fargo (WFC) overlap with 40% or more of OZRK’s branches and my concern is that they’re aggressively going after business that some of these other players don’t want.
I’m not predicting doom and gloom, but I think the maturation of the cycle is going to start squeezing the growth opportunities. Management does still have options to expand (OZRK is looking at opening additional RESG offices around the country), and I would also note the company’s efforts to expand outside of commercial real estate. OZRK is still very under-leveraged to commercial lending (C&I) at under 5% (versus an all-FDIC average of 21%) and consumer lending (10% versus 17%), and the company has been working to build up its capabilities in specialized segments of business and consumer lending, as well as leasing.
Before Bank of the Ozarks bulls light their torches and oil their pitchforks, I continue to believe this is a well-run bank with above-average quality and growth prospects over the next decade. I just think it pays to be cautious regarding a primarily CRE/C&D lender at this point in the cycle.
To that end, I’m still looking for long-term annualized earnings growth in the double-digits and mid-teens near-term ROTCEs. I believe there is still a lot to be gained from the bank’s efforts to introduce its RESG model in new markets, not to mention its policy of opening new branches in major markets where many of its rivals are closing branches. My preferred valuation approaches give me a wide fair value range, with ROTCE and discounted earnings-based approaches giving me numbers in the $40’s, but a 14x or 15x multiple on my 2018 EPS number supporting a fair value range in the low-to-mid $50’s.
The Bottom Line
Bank of the Ozarks has shown that it can take its core lending model and make it work in many different markets. Likewise, the bank has shown that it can successfully execute on M&A and maintain an uncommonly high level of growth while keeping expenses in check. A P/E-based fair value in the $50’s isn’t bad with that backdrop, but my ongoing concerns about the C&D exposure lead me to want a little more margin of safety.
Disclosure: I am/we are long JPM, BBT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.