Description

Summary:

Newtek is a stock in significant transition: the company converted to a bank from a BDC at the height of the banking sector’s implosion and cut its dividend 75% forcing significant shareholder rotation. While the operating model is little changed, its classification as a bank required new financial reporting. The accounting is complex and the sell-side itself is transitioning from BDC to bank analysts. While the stock has rebounded off its nadir due to a late inclusion in the Russell 2000, we believe there is still 50%+ upside in the next 12 months.

Why Does the Opportunity Exist? 

Newtek is the country’s 2^nd largest SBA lender, with about 70% of earnings driven by 1) SBA loan origination, servicing and interest margin, and 2) other lending sources (non-conforming C&I and conventional loans). The other 30% of earnings are tied to “Newtek Advantage” which is a suite of ancillary businesses such as payroll processing, document storage, website analytics, and transactional data.

In 2021, Newtek made the strategic decision to convert from a BDC to a bank to lower its cost of capital. Given the onerous regulatory demands faced by banks, the transition took 18-months to complete and closed in January this year, just in time to get lumped in with the banking system’s implosion. Within an eight-week period, Signature Bank, Silicon Valley Bank, and First Republic Bank collapsed, bringing the entire banking sector down with it (KBW bank index was -40% from February to May). Despite its unique business model and focus on SBA loans, Newtek was the proverbial baby thrown out with the bathwater and its stock sank 50% as investors hastily shed banking exposure.

Throughout NEWT’s lengthy transition from a BDC to a bank, the company was limited in what it could share with investors, resulting in an information vacuum during a period of significant investor uncertainty.  This caused two key points of misperception. Investors believed 1) Newtek changed to a banking business model on account of its regulatory reclassification, and 2) NEWT’s fundamentals would be hindered by the elevated interest rate environment like other banks. Both of these are incorrect, but a lack of investor communication and a new, and less clear, financial reporting structure led investors to sell first and ask questions later. The soured sentiment was further exacerbated by a 75% dividend cut and restatement of financials that wiped off 40% of the company’s book value. The restatement (which was required in order to adapt to bank financial reporting standards) has brought undue focus to the company’s book value, which is an important metric for traditional banking business models, though not for Newtek’s. 

Investment Thesis

Newtek is a higher quality company lumped into an out-of-favor sector that we believe will have a better than feared outcome for 2023. Looking into 2024, we believe the thesis will migrate to a positive earnings revision + dividend increase story that will likely garner a premium multiple. We think the stock is worth $26-30/share.

The financials of the business are quite complex. For those looking to get up to speed we would recommend the recent KBW and B. Riley initiation reports.  Management also does a really good job of dissecting the moving pieces in its investor presentation. Pages 25-26 provides a primer how the company makes money on an SBA loan origination and reserves for the unguaranteed portion held on its books.

Our key investment points are:

1. Lots of cheap banks, but Newtek is not impacted by the issues beleaguering the sector and fundamentals are quite strong.
2. SBA lending is a good business and loan quality improves in the current environment.
3. Ancillary businesses are a hidden asset.
4. Russell 2000 inclusion likely brings institutional eyes to the company which was historically lacking as a BDC.

Investment Point #1: NEWT is a Bank in Classification Only; Not Impacted by Issues Facing Traditional Banking. As part of its business reclassification, NEWT acquired a single bank branch in New York, and “purchase accounting” required the company to mark its assets and liabilities to market. While Newtek’s stock acted like the company was a traditional bank, the mark-to-market provided investors balance sheet visibility at the height of this year’s banking debacle/uncertainty. There are two key factors that differentiate NEWT’s business model from the rest of the banking sector. First, the main issue impacting banks (asset-liability duration mismatch) has not impacted Newtek as its primary funding source is not short-term deposits but rather permanent capital. Second, troubled banks have hemorrhaged deposits while Newtek’s bank increased deposits by 221% year-to-date through June.

Due to the superior yields on SBA loans (10%+), Newtek can pay market rates and attract deposits. The business is significantly over-capitalized leading NEWT to actually turn off the spigot of deposit growth. Newtek is targeting $875 million of SBA loan origination and $315 million of CRE/C&I origination in 2023, and is well capitalized to meet its targets.

Management is targeting $1.70-$2.00 of 2023 EPS based off these origination targets. While Q1 was off to a slow start, Q2 was robust leading management to pre-release key performance metrics and maintain guidance. Management has been able to maintain its EPS targets the entire year which is quite significant given the backdrop. For some perspective, the KBW regional bank index F12 EPS has declined by 20% YTD.

There are a lot of moving pieces, but the company provides extremely granular disclosures regarding its guidance in its investor presentation (see pages 33-41).

Investment Point #2: SBA Loan Quality Resilient in Current Environment. Investors are likely to conclude SBA loan volumes and quality will suffer in the current interest rate environment, making it challenging for NEWT to hit its targets. The market fails to understand that: 1) alternative sources of small business financing (such as credit unions and regional banks) pull out of the market in this environment, making the SBA one of the few alternatives, 2) with higher rates, fewer borrowers qualify for traditional bank loans, leading them to turn to an SBA loan, and 3) the quality of new loans improves as applicants (who personally guarantee the loans) provide financial statements using more conservative assumptions that reflect greater economic uncertainty.

As an anecdotal data point, on the 7/26 LOB earnings call, the CEO was asked about this dynamic:

Q - David Feaster

And I guess kind of with the whole idea that the -- most of the conventional lending could be slowing and a lot of banks kind of pulling back. Do you expect that to push more folks into the SBA and ultimately we could really potentially see growth accelerate kind of into next year and through next year?

A - James S. (Chip) Mahan III (CEO)

I would say it would be more on our conventional space, BJ, that you spent some time in. I don't know that the SBA space is going to be much different than it always has been. I will say that I want to get my hands on every great SBA lending officer in the country. So as we can get qualified A&B players, we will continue to hire those folks, but the sponsors that we do business with primarily focused on the $5 million to $10 million EBITDA businesses and those folks have a lot of capital. So, we're seeing that area grow substantially.

Investment Point #3: Ancillary Businesses are a Hidden Asset. Roughly 30% of Newtek’s business is in ancillary services such as merchant payment processing and payroll. As a BDC, these businesses were marked-to-market and included on the balance sheet. However, as a bank, SEC reporting does not include these as balance sheet items, thereby eliminating nearly $7 of book value. This accounting treatment further obfuscates the investment opportunity as banks are typically valued based on price-to-book-value, making NEWT look artificially expensive. As analysts look closer at the financials, we believe the consensus will eventually realize the valuation disconnect.

While these businesses represent around 30% of pre-tax income today, there is large potential for cross selling opportunities in the future as NEWT has a funnel of new leads from its SBA origination business.

Valuation

We think the stock is worth $26-30/share. Valuation is a little tricky at this point given its historical performance as a BDC does not provide the proper valuation range now that it is a bank and cut the dividend. Bank analysts are keener to focus on book value and earnings. There are obviously some inherent drawbacks given the ancillary businesses (which historically were valued at $7/share on the books) are no longer included in the balance sheet under bank accounting. Therefore, we believe P/E is the best metric. Regional banks have historically traded at 12x EPS. Given the current situation, the KBW regional bank index is closer to 10x today. We believe NEWT should be valued at 12x EPS or more given its superior fundamentals.

For 2024, we think the company is well positioned for positive earnings revisions and a dividend increase. Our current estimate is $2.30 for next year and at 12x, the stock would be worth $26/share. However, given Newtek’s superior balance sheet and earnings growth, we believe it should be valued at 15x, or $30/share. Prior to the banking sector implosion, NEWT had 2024 EPS guidance of $2.80-3.20. While that was withdrawn given all the moving pieces in the macroeconomy, we think this range sets a realistic expectation for 2025 if trends hold. While the dividend is yielding a healthy 4%, the business is overcapitalized, and we think an increase is a likely use of surplus funds.

Key Risks:

1. Loan Origination: The biggest driver to hitting 2023 earnings targets is SBA loan origination. The company set initial targets early in the year at $875 million and Q1 produced soft results. On July 5, the company reiterated its target and commented on strong originations in Q2.
2. Loan Book Deterioration: Newtek holds $800 million of loans on its balance sheet (primarily the 25% of loan originations that it does not sell into the secondary market). If the economy were to materially worsen, these loans would be at greater risk of default.
3. Ancillary Business Growth Slows: Newtek’s ancillary businesses represent 30% of pre-tax income. While these businesses have grown nicely over time, there is little data to track their progress. As a BDC, these assets were marked-to-market quarterly; however, they are not accounted for under bank reporting, placing a black-hole into a decent slice of earnings.

Catalyst

1. Meeting 2023 guidance

2. Reinstating 2024 guidance

3. Dividend increase