|Shares Out. (in M):||165||P/E||18.5||16.2|
|Market Cap (in $M):||14,400||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
First Republic is a simple story. The bank targets high net worth customers in the most structurally attractive markets and grows with them over time. At the heart of the business is a deep-seated client-focused service culture that has manifested itself in the form of one of the highest net promoter score rankings in the country, industry-leading customer retention rates, and strong loan growth supported primarily by existing customers and direct referrals. Through its entire history, the company has stuck to its knitting. Its loan mix has remained consistent in terms of geographic and product mix, and loan underwriting standards have always been extremely conservative, which has resulted in industry-leading loss rates through multiple cycles and strong, consistent profitability.
When the company was founded in 1985, its goal was to attract the next generation of high net worth households by delivering exceptional service, and the primary starting point for a new relationship was the origination of an attractively priced jumbo mortgage for the purchase of a first home. As such, the typical age for a new customer has historically been in their 30s, and FRC’s goal from that point on was to retain these attractive customers and grow with them over time. Having successfully applied this strategy for 30+ years now, the median age of its largest clients is 58, presenting the company with a natural tailwind to grow its wealth management business, but also a challenge in terms of its ability to re-stock with the next generation of wealth. Enter the millennial strategy.
In FRC’s core markets, high home prices, increased student loan debt burdens, and generational changes in the perception of home ownership have increased the average age of a first-time homebuyer by almost 10 years to over 40, significantly reducing the lifetime profit potential of the average customer. In response, FRC has introduced student loan refinance and partner loan programs as the new ‘hooks’ to gain access to the next generation of wealth earlier. By targeting the highest quality borrowers and offering attractive refinance terms with discounts for early pay, FRC is able to gain access the most attractive customer group 10+ years earlier, setting up an attractively long runway for future loan and deposit growth.
The architect of FRC’s historical and current strategy is CEO Mr. Jim Herbert. Mr. Herbert founded the company in 1985, took the company public in 1986, oversaw its sale to Merrill Lynch for $1.7bn in 2007 (3.6x TBV), and lead a management buyout from Bank of America in 2010 for $1bn (vs. a current market cap of ~$15bn). In his 32 years at the helm, FRC has increased its enterprise value at a 24% CAGR, while its stock price has increased at a 19% CAGR since rejoining the public markets in late 2010 (vs. +13% S&P). Mr. Herbert, 73, was originally set to retire at the end of 2017, but in agreed to stay on as CEO through 2020 and remain as Executive Chairman through 2025. Beyond Mr. Herbert, the company has a deep bench, and executive leadership could be set for many years as it appears the heir apparent is President Ms. Gaye Erkan, who is just 37 years old.
Since the 2016 election, FRC has seen its price-to-tangible book decline from ~2.2x pre-election to ~2x current whereas regional banks have seen their multiples expand 12% and money center bank valuations have expanded by ~1/3. As a result, FRC has seen its valuation premium compressed to 7% vs. regional banks (vs. 14% on average for the past five years and 16% vs. money center banks (vs. 41% on average pre-election), which strikes us as overly punitive.
To be clear, FRC’s premium should have compressed relative to peers, we just think the compression is overdone. It was not a beneficiary of tax reform relative to other banks, and the changes related to SALT & deductibility of mortgage interest have the most impact in its core markets. Moreover, management has ratcheted up its expense investment and issued shares to support its future growth over the past few years, which while consistent with its historical focus on the long-term, diluted the per share operating leverage despite the bank’s strong growth. In past few quarters, however, the expense ratio has started to level out, and after a recent equity raise, the bank appears sufficiently capitalized to provide loans in any environment, so we would expect better per share operating leverage going forward. Given our expectations for mid-teens loan growth and a growing stream of non-interest income, we expect the company to generate double-digit earnings growth over the medium-term, supporting an attractive total return.
First Republic is a California-chartered commercial bank and trust company headquartered in San Francisco specializing in providing personalized, relationship-based services, including private banking, private business banking, real estate lending, and various wealth management services. Roughly 83% of revenues are derived from interest income (primarily through loans but also from the ownership of other interest earning assets), and the remaining 17% of revenues is generated through non-interest income, primarily wealth management fees (~63% of non-interest income). As of June 30th, the company had total assets of $96bn, total deposits of $75bn, total equity of $9bn, and total wealth management assets of $131bn.
The bulk of its loan book is single-family loans and HELOC (55% of outstanding loans), but the company also provides loans for commercial real estate and multi-family (combined 23% of loans), and engages in business lending (14%), as well as a host of other loan activities (remaining 8%) including SF and MF construction loans, stock secured loans, partner loans, and student loan refinancing loans. Its business loan portfolio is concentrated in non-profit organizations/schools (36% of business lending) and PE/VC capital call bridge loans (36%), with the remainder spread between a variety of targeted verticals. The company maintains conservative underwriting standards across its entire book of business, with LTVs on average below 60% at the time of origination.
The company operates through 75 office locations primarily in San Francisco, Palo Alto, Los Angeles, Santa Barbara, Newport Beach, San Diego, Portland (OR), Boston, New York City, Greenwich, and Palm Beach – areas which are among the largest, fastest growing, and highest density in terms of high net worth households across the U.S. Almost 2/3 of outstanding loans are located in California, with the NYC metro area (22%) and Boston (8%) the other large regions.
Simple business model focusing on banking services for the wealthy. First Republic is different from typical banks in that it (1) primarily focuses on high net worth households (~50% of deposit accounts), which is defined as a household with over $1mn in investable assets and (2) limits its geographic presence to the most vibrant markets in the US. The company is a plain, vanilla bank – it does not engage in activities common for large banks such as investment banking and capital markets trading, and the majority of its revenue comes from traditional lending and wealth management services. Its core competency is delivering exceptional, relationship-based service with a strong focus on the customer. This is not a business that ‘nickels and dimes’ customer as management believes the short-term impact of foregoing fee income is more than made up by the goodwill engendered with a customer base that will only become more valuable over time. Instead, the company focuses its entire effort on providing a great customer experience, which helps with both retention and new client growth.
Thus far, management’s strategy has resonated well with customers as evidenced by an industry leading net promoter score, well below average customer attrition, and strong growth from existing clients and direct referrals (>70% of new deposits and loans), which has supported strong loan and deposit growth at the firm (+19% and +20% CAGR, respectively, since 2007).
Relationship manager quarterbacks the customer experience. At the center of First Republic’s business model is the relationship manager, i.e. the quarterback of the customer relationship. The relationship manager’s (RM) job is simply to deliver the services of the bank to the customer, acting as the customer’s advocate across the entire bank. From the initial point of acquisition – typically the origination of a jumbo loan for the purchase of a single-family home - the RM serves as the customer’s initial point of contact within the firm and generally remains their primary point of contact for the life of the relationship. In the customer’s eyes, the RM IS their bank. Even if they are promoted, the RM continues to manage existing clients because management does not want the customer to feel like they are being demoted to a new contact point just because their relationship manager gets more responsibility.
Secret to success is an entrepreneurial culture that is supported by a compensation structure that aligns everyone’s incentives appropriately. First Republic has an entrepreneurial culture in which the RMs truly ‘own’ the customer relationship and are compensated accordingly. Unlike most banks, RMs are compensated based on each customer’s entire relationship with the bank and more than half of the typical compensation to an RM comes from selling products other than loans. This makes it extremely challenging for a banker to leave the company and make as much money at another shop, which has contributed to employee stability – a key ingredient in a client-focused firm. In fact, since inception, 90% of loans have been originated by bankers that are still with First Republic.
First Republic also employs a ‘carrot’ and ‘stick’ strategy relative to RM compensation. RMs are compensated based on the products sold to clients, but in all instances, a material percentage of the compensation comes in the form of a multi-year deferred compensation trailer. Another interesting aspect of FRC’s compensation is the clawback provision where the RM is responsible for the loan performance throughout the life of the loan. If the loan goes bad, the banker needs to work it out, and if a loan cannot be worked out, the RM is on the hook for up to 3-4x the money he or she made originating the loan. This two-fold strategy directly incents RMs to provide suitable products for the customers (so they remain happy customers) that are also appropriately conservative to ensure losses are minimized.
Incentive structure supports conservative underwriting practices. With the clawback in place, lenders feel as if they are lending their own money, which results in a much more conservative credit culture than the typical business. The bank only offers a limited number of loan products and generally operates in a limited number of industries. Loan underwriting standards are extremely high, with average loan-to-values in the 50-60% range for residential loans while multi-family, CRE, and construction LTVs are closer to the 50% range, and these have remained consistent over time. The bank will aggressively price loans, but it will not be flexible on its credit standards.
Thus far, the strategy has been extremely successful. In its 32 years in existence, FRC has funded over $180bn of loans while cumulative charge-offs are only $325mn, which is equal to less than 1bps per year. For its single-family residential loans, cumulative net losses total just 7bps. And during the Dotcom implosion, FRC reported zero losses in San Francisco/Silicon Valley despite the NASDAQ declining 67% from 2000 – 2002.
Service culture and incentive structure creates a virtuous cycle supporting strong loan growth, negligible loan losses, and consistent profitability. In our view, the two drivers of FRC’s strong historical loan growth are (1) its service culture and (2) low loss rates, and in many ways its low loss rates actually make it easier to provide better service. Low loss rates enable the company to aggressively price loan products while still maintaining consistent profitability, so both the customer is happy and the bank is still able to earn a satisfactory return on investment. Since inception, FRC has never had an unprofitable year, and its net interest margin has been exceptionally stable despite significant volatility in the Fed Funds rate. Since 2002, FRC’s net interest margin has remained in a tight range of ~3.0% - 3.6%.
FRC has several opportunities to continue its strong growth. We see several attractive opportunities for First Republic to continue to grow its business, including:
Continue doing what it is doing. Despite strong growth in its core markets, FRC has just a 4% market share of high net worth households in its markets (up ~100bps since 2003), so there is an opportunity to grow by increasing market share within its existing markets. FRC should also benefit just by holding market share in these markets, as HNW household population growth in its core markets continues to outpace most markets in the world.
On a recent call, management noted that the uptick in rates had caused competitors to pullback their resources in mortgage lending whereas FRC is doing the opposite. Arguably, FRC should pickup market share even faster in less attractive environments as capital is withdrawn by its peers, suggesting the company can continue to grow at attractive levels even in choppier markets.