First Republic Bank: Strong Net Income Growth Comes With Too High Market Price (NYSE:FRC)

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First Republic Bank (NYSE: FRC) earnings were mostly in line with my expectations for the final quarter of 2021; however, the bank said lower interest charges than I expected. Going forward, strong double-digit loan growth will likely boost earnings. Meanwhile, the margin will likely only increase slightly despite the rising interest rate environment. Due to the nature of its loan portfolio, First Republic Bank’s net interest income is more sensitive to rate changes in the second year than the first year of a rate increase. Additionally, I expect funding to normalize this year, which will limit earnings growth. Overall, I expect First Republic Bank to report earnings of $8.39 per share in 2022, up 9% year over year. I’ve slightly lowered my revenue estimate for this year. The year-end target price is much higher than the current market price. Based on valuation and earnings outlook, I adopt a neutral rating on First Republic Bank.

Loan growth momentum will continue in 2022

In a year when many banks experienced declining loan balances, First Republic Bank managed to grow its loan portfolio by approximately 20%. This momentum will likely continue into 2022 due to the economic rebound. First Republic Bank operates primarily in the metropolitan areas of San Francisco, New York and Los Angeles, whose population density provides a good borrowing opportunity. Additionally, the country appears to be on track for an economic recovery as evidenced by the unemployment rate, which is now at the same level as at the end of 2018. In addition, First Republic Bank has prioritized the volume rather than rates, which led the bank to gain market share at the expense of the portfolio’s average yield. This strategy will likely continue to drive loan growth in 2022.

Management mentioned on the conference call that it expects loan growth to be around the 1920s average this year. Therefore, I expect loans to increase by 17% by the end of 2022 compared to the end of 2021. During this time, I expect deposits to increase more or less online with the loans. The following table shows my balance sheet estimates.

Source: Regulatory filings, author’s estimates

(In millions of dollars, unless otherwise indicated)

EX17 EX18 FY19 FY20 FY21 FY22E
Financial situation
Net loans 62,474 75,426 90 301 111,931 134,262 157,068
Net loan growth 20.8% 20.7% 19.7% 24.0% 20.0% 17.0%
Other productive assets 18,664 16,334 18,473 16,645 25,702 30,068
Deposits 68,919 79,063 90 133 114,929 156,321 182,873
Loans and sub-debts 10,072 10,474 14,276 13,529 5,477 5,261
Common Equity 6,828 7,738 8,706 10,206 12,265 13,617
Book value per share ($) 42.1 46.8 51.3 59.0 68.1 75.7
Tangible BVPS ($) 40.3 45.1 50.0 57.7 66.9 74.4

Fixed-rate loans to be repriced with a time lag

First Republic Bank’s earnings for the fourth quarter were mostly in line with my expectations, but interest expense was lower than I had estimated. The bank was able to reduce its interest charges by prepaying $4 billion in Federal Home Loan Bank (FHLB) advances, as mentioned on the conference call. Also, as mentioned in the earnings presentation, First Republic Bank reduced its cost of deposits to just five basis points in the fourth quarter of 2021, which is quite impressive.

Going forward, rising interest rates will likely increase the margin slightly. First Republic Bank’s loan portfolio is concentrated in single-family residential loans and home equity line of credit, which together accounted for approximately 59% of total loans, as mentioned in the presentation. Most of these home loans are based on fixed rates; therefore, interest rate increases will benefit sales with a lag. The Federal Reserve has forecast a 75 basis point hike in the federal funds rate this year; however, due to increased inflation, interest rates may even increase by 100 basis points.

Management’s interest rate sensitivity analysis shows that a 100 basis point increase in interest rate can only increase net interest income by 1.4% in the first year. Net interest income may increase by 6.9% in the second year of the rate hike. The following table in the presentation presents the results of management’s sensitivity analysis.

First Republic Bank Interest Rate Sensitivity

Presentation of the results for the 4th quarter of 2021

Meanwhile, the liquidity slowdown is likely to continue to weigh on the margin this year. As deposit growth has outpaced loan growth in recent quarters, access to cash has piled up on the books of the First Republic. As I expect loans and deposits to grow in parallel this year, excess liquidity is likely to remain high, thus keeping the margin at a sub-optimal level.

Management mentioned on the conference call that it expects the margin to be between 2.65% and 2.75% this year. Given these indications and the factors mentioned above, I expect the net interest margin to increase by four basis points in 2022, compared to 2.67% in 2021.

Additions of loans requiring additional provisioning

Similar to the past seven years, First Republic’s net charges remained negligible in 2021, according to details given in the presentation. The bank’s net write-offs were 0.00% of total loans last year. Additionally, waivers accounted for 0.51% of total lending in 2021, which is close to the 2016-2020 average of 0.57%. Given that net charges and provisions are in line with the historical trend and the economic threats on the horizon are limited, I believe loan growth will likely be the sole driver of loan loss provisioning this year. Overall, I expect provisioning to return to a normal level this year.

I expect First Republic Bank to report a provision charge of 0.09% of total loans in 2022, which is the same as the average provision ratio from 2016 to 2019.

Expected earnings of $8.39 per share in 2022

First Republic Bank’s earnings will likely rise this year on the back of strong loan growth and modest spread expansion. On the other hand, the normalization of the provision charge is likely to limit earnings growth. Overall, I expect the company to report earnings of $8.39 per share in 2022, up 9% year-over-year. The following table shows my income statement estimates.

EX17 EX18 FY19 FY20 FY21 FY22E
income statement
Net interest income 2,151 2,501 2,764 3,263 4,114 5,035
Allowance for loan losses 60 76 62 157 59 140
Non-interest income 460 543 577 654 920 1,039
Non-interest charges 1,640 1,917 2,146 2,426 3,147 3,858
Net income – Common Sh. 700 796 881 1,005 1,379 1,511
BPA – Diluted ($) 4.31 4.81 5.20 5.81 7.68 8.39

Source: Regulatory filings, author’s estimates

(In millions of dollars, unless otherwise indicated)

Compared to the estimates given in my last report on FRC, I have slightly reduced my profit estimate for 2022 as I have increased the provision estimate and reduced the non-interest income estimate based on fourth quarter performance.

Actual earnings may differ materially from estimates due to risks and uncertainties related to the COVID-19 pandemic, particularly the Omicron variant.

December 2022 Target Price Suggests Significant Decline

First Republic Bank offers a dividend yield of just 0.46% at the current quarterly dividend rate of $0.22 per share. Earnings and dividend estimates suggest a payout ratio of 10.5% for 2022, showing that there is plenty of room for higher dividends. Nevertheless, I am not including a dividend increase in my investment thesis because the payout ratio has also been quite low in the past.

I use historical price/book tangible (“P/TB”) and price-earnings (“P/E”) multiples to value First Republic Bank. The stock has traded at an average P/TB ratio of 2.25x in the past, as shown below.

EX17 EX18 FY19 FY20 FY21 Medium
T. Book value per share ($) 40.3 45.1 50.0 57.7 66.9
Average market price ($) 95.7 95.3 100.5 112.4 188.6
Historical P/TB 2.38x 2.11x 2.01x 1.95x 2.82x 2.25x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/TB multiple by the expected tangible book value per share of $74.4 yields a price target of $167.7 for the end of 2022. This price target implies a decline of 12.7% compared to the closing price on January 14. The following table shows the sensitivity of the target price to the P/TB ratio.

Multiple P/TB 1.85x 2.05x 2.25x 2.45x 2.65x
TBVPS – Dec 2022 ($) 74.4 74.4 74.4 74.4 74.4
Target price ($) 137.9 152.8 167.7 182.6 197.5
Market price ($) 192.1 192.1 192.1 192.1 192.1
Up/(down) (28.2)% (20.4)% (12.7)% (4.9)% 2.8%
Source: Author’s estimates

The stock has traded at an average P/E ratio of around 21.0x in the past, as shown below.

EX17 EX18 FY19 FY20 FY21 Medium
Earnings per share ($) 4.31 4.81 5.20 5.81 7.68
Average market price ($) 95.7 95.3 100.5 112.4 188.6
Historical PER 22.2x 19.8x 19.3x 19.3x 24.6x 21.0x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/E multiple by the expected earnings per share of $8.39 yields a price target of $176.6 for the end of 2022. This price target implies an 8.0% decline from at the closing price on January 14. The following table shows the sensitivity of the target price to the P/E ratio.

Multiple P/E 11.0x 16.0x 21.0x 26.0x 31.0x
EPS – 2022 ($) 8.39 8.39 8.39 8.39 8.39
Target price ($) 92.7 134.7 176.6 218.6 260.5
Market price ($) 192.1 192.1 192.1 192.1 192.1
Up/(down) (51.7)% (29.9)% (8.0)% 13.8% 35.7%
Source: Author’s estimates

Equal weighting of the target prices from the two valuation methods yields a combined target price of $172.2, implying a 10.4% decline from the current market price. Adding the forward dividend yield gives an expected total return of minus 9.9%.

A bearish stance would be inappropriate given the outlook for strong earnings growth. Therefore, I adopt a neutral rating on First Republic Bank. I will avoid this stock unless its market price corrects significantly from the current level.

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