First Republic Stock: Executing Well And Still Undervalued (NYSE:FRC)

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There’s little question that while banks are clearly benefiting from a combination of healthy loan demand and higher rates, the market is already pricing in the risk of a hard landing (recession) and a swift end to the good times. With First Republic (NYSE:FRC) previously taking a hit on uncertainties related to succession planning and continuing to perform well on a core basis, this fast-growing bank has once again emerged from the pack – solidly outperforming the broader bank sector and slightly outperforming the S&P 500 since my last update.

At this point I continue to like First Republic, but I can’t say it’s one of the cheaper names out there. There is a risk that First Republic’s lower asset sensitivity will lead to underperformance relative to other Main Street banks, but then First Republic could be a way to play a scenario where the Fed is less aggressive on rates, particularly with its strong organic loan growth capabilities. I can’t call First Republic my favorite name at this point, but I do see an argument for owning a bank that has a differentiated culture and growth profile at a comparatively reasonable valuation.

Stronger Earnings Led By Rates And Loan Growth

The upside for First Republic’s second quarter wasn’t really a mystery – the bank exceeded Street expectations on both core net interest income and fee-based income, with the former driven by stronger loan growth and better-than-expected rate leverage. Expenses were a bit higher than expected in absolute terms, but lower as a percentage of revenue, and the bank posted a strong pre-provision earnings number.

Revenue rose 23% year over year and 8% quarter over quarter, with net interest income growing 24% yoy and 9% qoq on 21% yoy and 6% qoq growth in average loan balances and a net interest margin that improved from 2.68% to 2.80%. Fee-based income rose 16% yoy, with 20% yoy growth in wealth management.

Expenses rose 20% yoy and 5% qoq, but the expense ratio declined 150bp to 60.5%. Pre-provision profits jumped 27% yoy and 12% qoq, with First Republic posting a $0.20/share beat at this core earnings line. Higher provisioning and a higher tax rate clawed back about $0.12/share, but the company still beat expectations by $0.08/sh on a core EPS basis.

Can First Republic Keep Up This Pace?

I’m bullish overall on First Republic’s prospects, but there are some “watch items” coming out of this quarter that investors should not ignore.

First, First Republic is not very asset sensitive during a period of rising rates (and potentially significantly rising rates, if a 75bp hike is coming soon). What’s more, at around 90% on an average balance basis, First Republic’s loan/deposit ratio skews a little high, and the bank is having to resort to on-balance sheet liquidity and FHLB borrowings to fund lending, as deposits grew qoq at a low single-digit rate.

Deposit costs rose 4bp to 0.09% for the quarter, but ended the quarter at 0.21% and are going to head higher as the bank has to rely on more expensive sources of funding like CDs. Management has been doing a good job of nurturing other funding sources, like business deposits, but I do still see a risk that First Republic gets squeezed some on its funding. To that end, I’d note that management guided full-year net interest margin to the “higher end” of 2.65% to 2.75% after achieving 2.74% in the first half of the year, suggesting some oncoming pressure.

I’d also note that capital call lending was down 2% qoq this quarter, with utilization down 150bp to 38.5%. That is arguably worse news for banks like SVB Financial (SIVB), Signature (SBNY), and Western Alliance (WAL), but this has nevertheless been an important growth business for First Republic for some time. Given the weakness in the broader stock market (and several large money center banks posting weak investment banking results), this isn’t surprising, but again it is worth watching.

One area where I’m not that concerned is the company’s core mortgage lending business. First Republic is primarily a mortgage lender, but one where there has historically been low correlation to the broader mortgage market. To that end, First Republic’s 28% yoy growth in mortgages was well ahead of the 9% yoy growth seen across the banking sector in the second quarter.

A key difference is that First Republic is a relationship-based lender that differentiates itself on customer service and long-term customer relationships. While many banks expand and contract their mortgage businesses through the cycle (hiring, then firing, thousands of workers to process mortgages), First Republic doesn’t. While that means First Republic lags some (if not many) of its peers on the trough-to-peak phase of the cycle, its mortgage business holds up better over the full cycle. This is also helped by the bank’s focus on “life-cycle” management – First Republic seeks out young high-earning professionals early in their career and then benefits as those customers upgrade their residences and add vacation and/or rental properties.

The Outlook

Credit isn’t a concern with First Republic, and I don’t expect that to change. Likewise, I’m not really worried about competition in its core private banking operations – many large banks are talking a good game about growing this part of their business, but it’s tough to break into relationship-driven businesses, and particularly with companies like First Republic where customer satisfaction scores are much higher than average. I’m a little more concerned about competition in the private equity/capital call lending business, but that’s a large market with a lot of business to go around.

I do see some risk that the Street basically gets bored with the name and assumes that with weaker asset sensitivity, the odds of meaningful earnings beats in the coming quarters are lower. In other words, while First Republic may still continue to post strong results on an absolute basis, the bar is already high here and exceeding that bar may be harder than for other banks. It’s a good problem to have from a long-term perspective, but one that can still weigh on sentiment.

While First Republic has done better than the Street expected, the results have been closer to my estimates and I’m not making a lot of modeling changes. My 2022 core earnings estimate moves up less than 1%, while my 2023 estimate moves down about 4% – largely on a weaker assumed NIM and recognizing some increased risk of a recession (or at least a weaker economy). While my mid-term earnings growth rate declines slightly (from 14% to 13%), my long-term growth rate is unchanged at around 12%.

Between slightly weaker near-term earnings and a higher discount rate, my earnings-based fair value declines about $7 to $176. Using a ROTCE-driven P/TBV model is less useful here as the shares have historically traded at a substantial premium to “fair” value. My ROTCE estimate hasn’t changed much, though, and even with a 10% haircut to the typical premium, the shares are still slightly undervalued provided you believe First Republic still merits a meaningful premium on this metric.

The Bottom Line

I have no doubt that with the weak performance of bank stocks this year, there will be several bank stocks that look cheaper, and probably substantially cheaper, than First Republic. The reality is that quality growth usually doesn’t get all that cheap, and there’s really nothing to suggest that First Republic isn’t still a rare high-quality growth banking story – with the shares offering double-digit upside and double-digit earnings growth potential, this is a name for more aggressive investors to consider now.

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