Benchmarking companies and stocks against peers is a time-tested strategy, but what do you do when a company doesn’t really have many true peers? That’s one of the challenges with First Republic (FRC) and its differentiated high-service model focused on providing banking and wealth management services to high net-worth individuals and select lending clients like equity investors, non-profits, and schools. While “it’s different this time” are some of the most dangerous words in investing, it is a relevant to First Republic at least insofar as this model really is different.
These shares have modestly outperformed regional bank indices since my last write-up (when I thought the shares offered a relatively rare entry point at a reasonable price). I don’t think the shares are expensive now, per se, but I do think the valuation is fair and I think First Republic faces some increasing near-term headwinds that could dampen growth and raise a few more pointed questions about how much of a premium the shares really deserve.
Okay Results In An Okay Quarter, But First Republic Usually Does More
First Republic may be, slightly, a victim of its own success and the higher expectations that its performance has driven from its sell-side coverage. In a quarter where most banks seem to be reporting earnings pretty close to expectations, First Republic’s adjusted core earnings (adjusted in part for a more normalized tax rate) were basically just in line with expectations.
Revenue rose 13% year over year, but fell about 1% sequentially and came in about 1% short of expectations. Net interest income rose 14% yoy and 1% qoq on basically flat net interest margin, with all of the growth coming from the company’s expanding balance sheet. While flat net interest margin is perhaps a bit lackluster, it was still a little better than expected.
Fee income rose 7% yoy on a core basis and fell 9% sequentially, coming in about 8% shy of expectations. Wealth management was the primary culprit, as revenue declined 10% qoq despite an 11% increase in assets under management, and this segment alone accounted for about $0.06/share of earnings underperformance. It doesn’t seem like there’s anything particularly wrong with the wealth management business, rather it was just the impact of recent equity market volatility (something seen at JPMorgan (JPM), PNC (PNC), and others to varying degrees).
Operating expenses rose 14% yoy and 5%, which was in line with expectations. Core pre-provision profits rose about 12% year over year, but fell about 10% sequentially and came in about 1% shy of expectations. First Republic posted lower than expected provisioning expense, helping offset some of the PPOP-level miss, and a lower tax rate added the rest. Tangible book value per share grew 13% over the prior year.
For Most Other Banks, This Loan Growth Is No Problem… But FRC Isn’t Most Banks
Such are the expectations built around First Republic that 19% yoy/2% qoq period-end loan growth was a disappointment (against a 0.6% qoq period-end increase in loans for the “average” small bank as per Fed data). Although commercial lending was the most noticeable outlier (with a 3.5% contraction in loan balances), all categories missed.
The shortfall in commercial seems to have been driven by lower business line utilization (33% versus 37% in the fourth quarter), and particularly from equity/venture investors. Single-family mortgages were up over 21% and 3% – there has been some speculation lately that First Republic could be vulnerable to a slowdown in jumbo mortgage origination, and while I don’t totally dismiss that, I don’t think it’s a big problem at this point.
That said, originations were weak this quarter (down 8% / down 20%), with single-family down 6% and 19%. Multifamily originations were down even more (down 20% and 31%), while commercial originations were up 11% from the prior year but down 21% from the fourth quarter. I’ve never found origination numbers to be quite as useful as some analysts seem to, but I’d say this is enough to flag loan growth as “something to watch” for the next few quarters (which really isn’t anything new).
Rising deposit costs are also a challenge for First Republic, though not to the extent as for other banks. Deposits rose 15% yoy and 3% qoq, and unlike JPMorgan and PNC, non-interest-bearing deposits kept up, with 14% and 4%-plus growth. CDs grew even faster, though, at 44% and 14%, and it looks like this is going to be a larger source of funding growth in the coming quarters, which is likely to keep upward pressure on deposit costs (which were up 27 bps/6 bps this quarter, but still very competitive next to the larger regional and super-regional banks).
My biggest concerns for First Republic mostly revolve around whether the company can maintain such a strong pace of loan growth and what a flatter yield curve will mean for the bank’s margins. Because of the nature of the bank’s lending, and the consequent longer duration of First Republic’s loan book, a flatter yield curve is a bigger issue here, as First Republic will find it harder to pass on short-term funding costs through higher loan yields (loan yields were up 29 bps/7 bps this quarter, less than at JPMorgan, PNC, or Commerce Bancshares (OTC:CBSH)).
To be clear, I view these as shorter-term cyclical challenges as opposed to structural business quality challenges. There are some business risks here, including deposit concentration, and a greater-than-average reliance on the health of the San Francisco area, but First Republic has a strong service-driven model that I believe is well-positioned to continue to take more share in the high net-worth space, particularly given that the IT investments that so many large banks are prioritizing (often with the goal of reducing employee headcounts) aren’t really going to appeal quite as strongly to this customer base.
I’ve made some tweaks to my model, but nothing all that significant; a flatter yield curve would probably be the biggest factor that would change my numbers, though a sudden drop in credit quality would be impactful as well (though something I see as lower probability). I’m still looking for double-digit growth in the mid-teens, and that supports a fair value around $103. While P/E and ROTE-P/TBV would point to lower fair values, this is where the lack of a true peer group starts to matter, as I don’t think the normal rules should necessarily apply to First Republic.
The Bottom Line
I thought there was a window of opportunity back in January to buy First Republic at a price below my estimate for fair value, and that window has basically closed since then. I don’t think there’s anything wrong with owning a fairly-valued stock in a company that is likely to generate mid-teens growth in a sector where the largest players will likely be happy with low-to-mid-single-digit growth over that same time, but given where we are in the cycle, I can understand if investors would prefer to wait for another window of opportunity, particularly as the shares do seem to offer periodic pullbacks.
Disclosure: I am/we are long JPM. 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.