FB Financial: It’s Going To Get Worse Before It Gets Better

With the Fed hiking interest rates another 50bp as of this writing and signaling a willingness to go even further, it’s going to be even harder to be in the banking business over the next several quarters. Tennessee’s FB Financial (NYSE:FBK) is a case in a point, as management has already said they’re going to pull back on lending in the face of rising deposit betas, and with little help coming from mortgage banking or credit, pre-provision profit growth is going to get harder to come by.

I believe FB Financial’s operations in Tennessee do have some value, given the above-average growth in the region, but I believe today’s price pretty fairly reflects that value. Mid-to-high single-digit core earnings growth can support a fair value in the mid-to-high $30s, but the stock is less attractive on multiples-based valuation and I frankly see more things that could go worse over the next 12 months relative to expectations than go better.

Deposit Costs Driving A Change In Strategy

FB Financial had been enjoying some robust loan growth, with loans up about 25% year over year and almost 6% quarter over quarter in the third quarter (on an end-of-period basis), and loans were up almost 30% from the end of 2020 as commercial lending recovered and FB Financial saw growth in demand for construction loans.

Management has already signaled that growth is going to slow substantially in the coming quarters, and rates are why. It may seem paradoxical that a bank would curtail lending when rates are heading higher, but there are two compounds to spread income – interest income from loans (and other sources, like securities) and the cost of the funds loaned out.

FB Financial has a respectable deposit franchise, but that’s largely tapped out now. The period-end loan/deposit ratio climbed above 91% in the third quarter, and deposit costs accelerated an above-average 27bp to 52bp. While FB was actually one of the relatively few banks to see a sequential increase in non-interest-bearing deposits (up about 2.5% eop), it’s not enough to cover loan funding and the bank has had to turn to other, more expensive, sources of funding like FHLB advances (which carried an average yield of 2.6% in the third quarter).

With these pressures, net interest margin is likely to peak in the first half of 2023 (quite possibly in the first quarter), and I expect year-over-year declines in the third and fourth quarters. Coupled with modest loan growth, net interest income will likely plateau for several quarters – the year-over-year comps will look good in the first half and then shrink considerably.

The kicker here is that FB Financial really hasn’t done anything wrong. They don’t seem to be writing bad loans (though the construction lending concentration is a risk), and they’re not chasing growth for growth’s sake. Moreover, the cumulative deposit beta through the third quarter was actually quite good at 12% – well below the average. Still, this is the reality for banks now as commercial depositors start looking at deposits as funding sources and retail depositors withdraw money from lower-yielding bank products to chase yields elsewhere.

Fee-Based Income Won’t Help

I’ve written in the past that strong fee-generating businesses can be valuable offsets to spread income challenges, but that’s not the case at FB Financial. While FB Financial has historically garnered meaningful revenue from non-spread sources, that has been overwhelmingly concentrated in mortgage banking (over three-quarters of 2021 non-interest income), and that business is collapsing as high rates decimate the mortgage market.

The third quarter saw mortgage banking revenue fall 73% yoy and 45% qoq, with commitments down 56% yoy and 32% qoq and gain-on-sale margin down 60bp and 48bp to 1.95%. This has pushed the business into a pre-tax net loss in the last three quarters, and given where rates are, there’s no reason to expect a meaningful recovery until rates start heading lower. If there’s good news, it may be that I also don’t see this business getting too much worse from here and management could look to cut costs further to a point where it’s enough to just “keep the lights on” for that eventual recovery.

Credit Will Become More Significant To The Story

I don’t think there is an underwriting problem at FB, but I do think tougher days for the credit cycle are ahead. There are already multiple data points showing worsening consumer credit metrics (credit card delinquencies and other consumer credit lines), and the economy is definitely going to slow in 2023, possibly to the point of a recession. With that, I expect commercial delinquencies to start rising, leading to higher credit costs for banks.

The biggest area of concern for me with FB is the sizable (18% of loans) construction loan portfolio. It’s at least partly unfair to paint with a broad brush, but C&D loans typically generate some of the highest losses for banks in downturns, and I’m fairly bearish on residential and non-residential markets next year. FB’s portfolio should do better than the “average” C&D portfolio given that a substantial portion is in single-family homes to be sold, but there is still a risk that builders won’t be able to move those houses (or at the anticipated prices) and the commercial land exposure is also meaningful.

The Outlook

On the whole, I’m not that worried about FB Financial – the bank is well-capitalized, the various quality metrics are generally pretty good, and the bank is leveraged to above-average markets in Tennessee (with faster population and income growth than the national averages). Moreover, I think management’s decision to pull back on lending in the face of higher funding costs shows a concern for margins and returns (as opposed to chasing growth for its own sake). My issue is more that I see more things that can go wrong than right over the next year or so, and the valuation isn’t exactly discounted.

Given the served markets, FB Financial should be able to generate 6% to 7% long-term core earnings growth over the long term, but that only gets me to a fair value of around $38 now. Likewise, neither ROTCE-driven P/TBV nor P/E suggests substantial undervaluation, with the shares already trading at about 10.5x my FY’23 estimate. While a better growth profile can support an above-average multiple, I don’t see much relative upside there for the multiple or the EPS estimate.

The Bottom Line

Operating conditions are going to get more challenging for regional banks, and FB Financial is no exception. While I think there are opportunities out there where banks can leverage spread-independent fee-generating businesses or under-utilized core deposits to maintain better pre-provision profit performance, FB isn’t one of them. In a space where I’m getting more cautious, this is a name that I’m comfortable to pass on for now but will revisit in future quarters.