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Allocating capital and managing risk are critical duties for bank managers, and I think Washington Federal (NASDAQ:WAFD) (“WaFed”) has been doing a better job of it than I’d expected when I last wrote about the company. While I liked WaFed and saw improvement, I didn’t think there was quite enough undervaluation to merit a bullish stance. Since then, the shares are down slightly, but have outperformed smaller regional peers by about 5%.
WaFed still doesn’t look like a remarkably cheap bank, and there are some risks to the outlook (including management’s own guidance for slowing loan growth). The company has made good progress on costs, though, and I can see a clearer path now toward a higher-quality, lower-cost deposit base to support a quality, growing loan portfolio. An economic slowdown over the next 12 to 18 months is certainly a risk (particularly in key states like Texas), but I do lean more positively on this under-followed company.
Going Risk-On With The Loan Portfolio
One of the more striking changes at WaFed, particularly in the last quarter, is the company’s rapid shift toward construction loan underwriting. Construction loan originations rose 53% sequentially in the fiscal third quarter (calendar second quarter) and made up almost 40% of total originations. Not surprisingly, construction loan balances grew significantly, up 24% qoq on a gross basis and 16% on a net basis.
This isn’t wholly surprising, as WaFed has long had above-average exposure to construction lending, but it does at least help explain how the company has managed to significantly exceed net interest margin improvement estimates (up 40bp yoy and 32bp qoq in the last quarter). Construction loans are typically among the highest-yielding loan categories, and deploying capital to this category is not only a good way to leverage construction growth in states like Arizona, Nevada, and Texas, but also quickly boost average loan yields.
This also fits in with a multiyear strategy to shift more and more lending toward commercial lines. Less than 50% of WaFed’s lending was commercial in 2014, but that percentage is now close to 70%, and about 85% of FQ3 originations were in commercial categories.
Of course, this strategy also carries risk. Construction loans typically default at higher rates than other categories, and while WaFed’s construction portfolio looks very strong today from a credit quality standpoint, a sudden downturn in the economy is a risk. This isn’t management’s first rodeo and I’m not trying to overstate the risks here, but I would just note that banking doesn’t typically offer “free lunches”, so there are risks tied to pursuing faster-growing, higher-yielding lending categories.
Funding Costs Are Still A Concern, But Improving Customer Service Helps
Going back to the start of the year, one of my main concerns for the banking sector was that deposit betas would end up coming in higher than expected for this next phase of the cycle – meaning that as rates rise, banks would have a harder time hanging on to low-cost deposits and would have to pursue more expensive sources of funding.
There are a few other issues here as it pertains to WaFed. First, the bank has never been especially good at attracting sticky non-interest-bearing deposits (the cheapest funding you can get). While there has been substantial improvement over the years – NIB deposits were 9% of the total years ago and are now 20% – the bank is still below peer-group norms.
Another issue is the high loan/deposit ratio – 97.5% on an average balance basis exiting the last quarter. Between a lack of NIB and a high LDR, WaFed will have to turn to more expensive funding sources to support ongoing loan growth, and that will pressure the bank’s NIM leverage. That explains, at least in part, why this bank has fairly average rate sensitivity, but as the rate hike cycle is close to ending, that’s not much of a drawback.
There is evidence of improvement, and I don’t think that’s trivial. Net Promoter Scores (a consumer satisfaction metric that basically measures how likely a customer is to recommend a business) are an underappreciated metric in the banking sector, as banks with high scores (like First Republic (FRC) and Cullen Frost (CFR)) typically have better deposit bases, better service penetration, and overall more profitable operations.
WaFed’s NPS has improved from 17 in 2017 to 48 in 2021, and while progress on growing NIBs has been slow, I do think this is a positive indicator not only for deposit quality, but WaFed’s ability to generate fee income from its customer base.
The Outlook
Quite a bit has gone right, and better than I’d expected, for WaFed since my last update. While loan growth has been slower than I’d expected, NIM improvement has been much better and the company has done an excellent job of controlling costs and generating positive operating leverage (FQ3 revenue grew 12% qoq on a 1% decline in reported expenses). With that, the bank’s long-term target of a sub-50% efficiency ratio is looking a lot more credible than I previously thought.
One key watch item, though, is how much the bank will need to spend on IT and staffing on an ongoing basis to remain competitive with larger bank peers targeting many of the same markets. In commercial lending, customer service is often a key differentiating factor, and it takes money to build and maintain a structure that includes loan officer expertise (being able to find and write the right business) and the ability to make quick underwriting and funding decisions.
I’ve increased my FY’22 and FY’23 core earnings estimates by more than 10%, and while I do think some of that is being pulled forward from more distant years (a faster ramp in NIM, for instance), I think WaFed’s long-term earnings power looks better than six months ago – particularly if this progress in operating efficiency is sustainable. Relative to my last update, I now believe that WaFed can grow core earnings at a double-digit rate over the next five years (versus a 9%-plus prior growth rate), with long-term growth in the high single digits (about a point higher than my prior estimate).
The Bottom Line
Between discounted long-term core earnings modeling, ROTCE-driven P/TBV, and P/E (using a forward multiple of 12x), I believe fair value for WaFed is now in the $40 to $43 range. That’s not bad upside relative to today’s price, even if there are banks trading at even wider discounts. I do see risks of a sharper slowdown in WaFed’s key markets in 2023, but even relative to those risks this looks like a name worth considering.
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