Home building stocks have been on fire lately, with most rising over 20% in the month of July alone. On top of the great results culminating from earnings calls of these companies, recent monthly new residential construction data from the U.S. Census Bureau looks promising, which could be a great boon for People’s United Financial (PBCT), a regional bank with already a large exposure to residential mortgage loans.
I outlined the emerging housing construction statistics in a recent SA blog post, as the dip in activity from the COVID-19 lock downs seems to be lifting. Another promising statistic: the price of lumber has also shot through the roof (no pun intended) in the month of July, further reinforcing the positive demand seen post-crisis.
With low interest rates seeming here to stay for quite a while, particularly with Jerome Powell’s announcement that the Fed intends to keep them there as long as the economy needs, the demand for mortgages could become a major catalyst for the banks willing and able to absorb a boon in demand.
Taking a look at the major U.S. regional banks in the S&P 500 (CFG, CMA, FITB, FRC, HBAN, KEY, MTB, PNC, RF, SIVB, TFC, USB, ZION), I went ahead and made a chart displaying what percentage of each bank’s loan books currently (as of their latest 10-k) make up the total loan portfolio, with an additional column for HELOC (home equity line of credit) added for the final column at the right “Total Residential % of portfolio”. While low rates is no guarantee for higher HELOC demand and usage, I’ve included it there as they are related to residential and do make up a large portion of the book for some banks on the list (People’s United included).
As you can see, PBCT far outweighs all other S&P regionals with 24% of their book consisting of residential mortgages, with USB the next closest at 20%, and the large majority sitting at somewhere between 15-17%. When you include HELOCs, the bank also takes the lead in this residential/consumer exposure (29%), with RF and HBAN close on its heels at 28% and 27% respectively.
Let’s take a closer look at the loan situation for PBCT, from their 10-k:
You can see that there has been steady growth across the board for both the Total Commercial Portfolio group and Total residential mortgage group over the last 5 years, in no small part from recent acquisitions (BSB Bancorp, United Financial, and First Connecticut.
Though the retail banking side of the business, which includes these residential mortgages and HELOCs, and consumer deposits, makes up a much smaller portion of the net income than commercial banking does, their retail earnings has shown incredible growth over the last 3 years.
From 2018 to 2019, retail banking grew 75.2%, after just earning a 233.5% growth the year prior. To explain the significant increase in net interest income for the segment, which in great part helped drive the great growth in earnings, management had this to say (bolded emphasis mine):
The $87.9 million increase in net interest income primarily reflects the benefits from an increase in average residential mortgage loans, new business yields higher than the total portfolio yield, as well as higher net FTP funding credits, partially offset by an increase in interest expense.
Of course, that data reflects the results before COVID, and that impact must also be discussed regarding the latest developments and fallout. Sheen Bay Research did a nice article discussing the company’s provision expense and their need to keep it elevated through Q2, but also did believe that PPP would support earnings through the tougher climate ahead.
From the company’s latest earnings call presentation (July 23), Q2 net interest income has actually increased from Q1, with increase in deposits almost absorbing the decrease in loans:
Loan forbearance, another interesting statistic to watch as parts of the economy experience a deep recession, has been updated to include 11,465 loans with $6,161 outstanding in commercial loans, and 2,957 retail loans with $1,009 outstanding, for a total of $7,170. Considering the company’s total size, this doesn’t appear to be catastrophic as of yet.
Comments by management on their latest earnings call provide good insight into the situation and reflect a positive outlook for the company through this pandemic shock (earnings call transcript here):
Positively the trends in the initial forbearance request have slowed materially, and we have been pleased to receive payments from 38% of the accounts, representing 19% of loan balances since they were in deferral. We also continue to assess the needs of customers that may require extended release. Second round forbearance requests are subject to a more extensive due diligence and credit analysis to confirm additional relief is needed, as well as the viability of the business in this new economic environment.
While still early in the process, based on conversations across our customer base, we expect second round forbearance levels will be meaningfully less than the first. We believe this is a testament to our approach to relationship banking and reflects the strong capital and liquidity profile of our customers.
Considering Long Term Growth Potential…
Looking past the struggles ahead and towards the future, the question becomes whether PBCT can continue its strong growth in commercial and retail banking, driven in no small part by its residential mortgages and recent acquisition strategy.
As it comes to companies that rely on certain regional locations (industries like aggregate mining, home builders, and auto dealers are first to mind), it helps to also evaluate the changing demographics picture for the locations that represent large portions of a company’s success. In the case of regional banks like PBCT, a strong geographical positioning could become a competitive advantage if changing population leads to economic prosperity in those regions. Again from the latest earnings presentation:
Compare this to the latest population growth statistics, and you wonder if there’s an impeding limit to the strong retail growth that the company has seen so far. With none of the states above ranking in the top 10 in population growth in the United States, both on a total growth and percentage growth basis, the continuation of population trends over the last 10 years into the next 5-20 years could present a long term obstacle for PBCT, or force expansion outside of their comfort regions.
Bullish Catalysts, and the Excess Returns Valuation
Nevertheless, a secular boom and/or recovery in residential real estate and the U.S. economy could lift all ships and make the challenging demographics a moot point, particularly for a smaller company like PBCT.
For this bank stock, I’ll use an excess return valuation model, as taught by Damodaran from NYU Stern and also used on bank stocks by fellow SA contributor David Ahern.
Here’s the inputs for the valuation model:
- ROE = 7.96%
- Retention ratio = 44.09%
- Expected growth rate = 3.51%
- Cost of equity = 8.8%
- Beta = 1.25
- Risk-free rate = 1.3%
- Risk premium = 6%
The stock appears to have a fair value of $19.02, which is just under the stock’s latest high in 2018. Of course, the period ahead may present some difficulties and make such a valuation hard to justify with a dip in ROE and growth– but if the company can return to a satisfactory position after the pandemic then it could very well achieve such long term results.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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