Value Investors Club / BANK OF THE OZARKS (OZRK)

Description

Bank of the Ozarks (ORZK) is a $5.5 billion market cap commercial real estate driven bank based in Little

Rock, AK. The bank differentiates itself from peers and brings in business based on its ability to participate

in complex deals and close faster than peers (as loans are not syndicated). I would argue itin turn protects

shareholders by underwriting loans at a conservative loan-to-value and generally maintaining a senior

secured position to other lenders. The bank has been managed for twenty-eight years byCEO George

Gleason. It has consistently generated strong earnings growth and high ROA and ROE and with minimal

loan losses in its non-purchased loan book. The record suggests Ozark is a well-run bank and I believe the

stock has approximately 30% upside over the next two years assuming no multiple expansion. Should the

growth opportunity be realized, the stock has the potential for a multi-year run of mid-teens stock

appreciation. Pluto wrote up OZRK in March of 2016 and his write up provides additional background and

I recommend it.

The bank trades at a 15 P/E and a 2.15x price to tangible book value. After trading at a P/E in excess of 20,

the bank has seen the multiple decline to its current levels, in part, on the heels of the loss of the long-

time head of its Real Estate Investment Group (RESG) on July 27, 2017 and in 2016, a Muddy Waters

presentation highlighting the risks of commercial real estate given growth. However, I believe the bank

when viewed as the real estate lender it clearly claims to be, is conservatively managed and that its

earnings and returns are real and warrant at least the multiple it now has, if not reclaiming some of that

which has been lost recently should its growth initiatives play out successfully.

Consensus earnings for Ozark are $2.96 for 2017, at 15% increase over 2016; and $3.33 for 2018, a 13%

increase. Based on the unfunded loan book, growth plans that are underway, and their track record, I

believe earnings should continue to grow mid-teens until the next recession hits. One way to look at a

return would be a mid-teens annual return as earnings and book value grow and assuming the multiple

stays at its current 15x level. Pinning that down to fair-value over a reasonable time frame: $3.33 earnings

for 2018, $3.82 for 2019. Fifteen times $3.82 equals $57 or about 30% return over the next two years.

Upfront, I understandOzark attracts detractors and I respect the concerns. However, I believe

management has proven themselves and I believe they will continue to do so; that is, in absence of a

recession. While I believe conservative underwriting will prove a backstop of safety for the business in a

real estate downturn and limit write-offs, conservative underwriting is not going to keep the stock price

up if the economy or real estate rolls over. If you believe we’re on the cusp of a recession and I – for now

– do not, then this (or any other bank stock) is not the stock for you.

Arguably the roots of the real estate driven bank Ozark is today began in 2001 with the opening of a loan

production office Charlotte, North Carolina followed by consistentadditionalexpansion in the Carolinas

and other Southern states. The focus of loan production being what the bank knows best: commercial real

estate. Over time, loan productionoffices would ultimately be converted to full-fledged deposit taking

banks. After proving their expansion model in markets closer to home, they ramped up expansion across

the south with offices in Austin (2012), Atlanta (2012 and Houston (2014) and more recently beginning to

build the outline of a national footprint with offices in New York (2013), Los Angeles (2014) and San

Francisco (2016).

The company is currently working to build out these and their other more recent expansions. Loan

production from these offices should continue to grow and over time deposit growth should begin to

follow. Milestones to watch for include loan production in non-South cities that seasons without

unexpected losses and with local deposit growth. I argue that that as the market begins to perceive that

the first expansions outside the South are successful it will switch from worrying about these first non-

South branches and instead focus on all the markets to which the company may soon expand. If they can

make it in NYC, LA and SF, the success will bring confidence that they can successfully enter lower tier

cities, of which there is a long list.

A sense that the growth opportunity has a long-term run ahead and may allow the P/E multiple to expand

from the current 15x up in the direction of 20+ which it has been in the recent past. My investment thesis

is not based on multiple expansion, but would benefit from it should it occur. For instance, an 18x multiple

applied to the $3.82 of prospective 2019 earnings I laid out earlier implies a $68.75 fair value and 56%

upside. However, as noted, this is not part of my thesis.

The bullish argument for Ozark and its growth plans is that they focus on real estate because that is what

they know best and do well. This is not unlike in some sense a credit card company that focuses on

consumer credit or an aircraft lessor focused on aircraft leasing. I do get the sense that negative

arguments against the bank often imply that the bank is hiding their real estate exposure and the fact that

their growth is tied to it. Here is the latest presentation. An investor could hardly feel less forewarned.

A link to the OZRK presentation:

http://ir.bankozarks.com/Cache/1500105223.PDF?O=PDF&T=&Y=&D=&FID=1500105223&iid=1005468

The company has grown their real estate loan book by providing project sponsors with 2-3 year

construction loans that can be accessed fast. In turn the bank focuses on senior loan positions in low

leverage, high quality projects. The bank argues that a project sponsor, should the project meet Ozark’s

standards, can obtain a loan in about two months based on one vetting with Ozark. This compares to five

or six months via other sources and often with multiple vettings. The sponsor improves their IRR by

accelerating the project and avoids some headache by only dealing with Ozark. Ozark in return gains

market share and obtains a loan with a conservative risk profile.

Speaking to the conservativeness of the bank’s loan operation, as the bank has expanded the geography

of its real estate loans (in the Real Estate Specialties Group or RESG) it has also reduced LTV (Chart 1.) and

in the financial crisis had minimal RESG losses (Table 1.) and always maintained positive earnings (Table

2.)

Chart 1: Recent history of reducing LTC and LTV.

Table 1: RESG historical losses.

Below it Table 2: Ozark earnings before, during and immediately after the financial crisis.

Positive even during the crisis.

I base my confidence in the CEO who has been in charge since the end of the 1980’s and his successful

long-time track record includes managing to maintain stable bank earnings through a nearly once in a

century banking crisis. And that their business model makes sense to me. That noted, I welcome alternative

views. Safe to say views on this name seem to be binary in nature. The comment thread from Pluto’s write

up includes a reasonable detailing of the negative view. I can’t disprove the negative any

better than he can.

Ozark is unique in that it has had the same CEO for 28 years, a rare occurrence I suspect. The book The

Outsiders: Eight Unconventional CEOs…” highlights eight best in class hall of fame CEOs (e.g. Cap Cities’

Tom Murphy and Teledyn’s Henry Singleton) all of whom were at the helm for extended periods and

highlights the business traits behind their success. Evidence of success the book argues is best measured

in terms of the performance of the stock price compared to both a group of peers and the S&P 500. By

this measure the stock has done well. The period since I have the stock trading in 1997 to today shows

the stock beating the market and the KBW Bank Index as follows in Table 3 and Chart 2:

Table 3: Return and CAGR with dividends of OZRK, S&P Total Return, KBW Bank Index

Chart 2: Chart of Total Return OZRK (blue), S&P Total Return (red), KBW Bank Index (green).

I do not have all the details of the Muddy Waters 2016 argument, but in part it is posited that the bank

will not be able to finance their unfunded loan commitments. I suspect they will through a combination

of deposit growth, further acquisitions, debt, and equity. If they can’t do it by those sources they can sell

off the loans. That would blow the growth thesis, but would not generate losses. As with most negative

arguments, Muddy Waters cites the banks surprising leverage to real estate. Again, this is only a surprise

to someone who hasn’t opened their presentation and/or believes a lender that specializes is a not a valid

business model. It also seems to not give credit to the bank for continuing to decrease loan-to-value as

they expand to geographies. The bank has become more conservative as it grows. In the end, specialized

lenders and generalized lenders get killed by poor practices, not because they focus on one industry.

I argue that this bank management is one to bet with, but only if one is comfortable that there is not going

to be a real estate recession soon.

Risks: A real estate recession or a general recession. Failure of Ozark to be able to succeed in geographies

outside their home market(s).

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Proving of the growth model in new markets which in turn lends credibility to further expansion to additional untapped markets.

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			2017	2018
Price:	44.10	EPS	2.96	3.33
Shares Out. (in M):	128	P/E	15	13.24
Market Cap (in $M):	5,653	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0