|Shares Out. (in M):||1,256||P/E||0.0x||0.0x|
|Market Cap (in $M):||5||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
Priced at $3.82 per share, Regions Financial (RF) is effectively a call option on the failure of the current economic situation in the U.S. to become a full fledged double dip recession and on atrocious investor sentiment toward banking and financial stocks. Judging from the recent plunge in bank stocks, which has taken much of the sector, including Regions, to valuations well below tangible book value, it appears that investors are pricing in a dire outcome with respect to credit. No doubt this is influenced by the daily drama in Europe, flagging economic growth in the U.S. and a litany of messy regulatory and legal squabbles involving foreclosures, mortgage put-backs and other issues. The resulting sell-off in bank stocks has been largely indiscriminate. Money center banks and brokers with unwieldy balance sheets and difficult to handicap loss potential have fallen sharply, which is not surprising, yet so have most regional banks, which in comparison are largely plain vanilla. I believe that the tightly correlated collapse in bank stocks provides the opportunity to purchase attractive franchises like RF at bargain basement prices. If you're contrarian and/or bullish on the economy, you will probably make money owning nearly any regional bank, but I believe several factors highlight RF's relative attractiveness and return potential should the world not end.
Before going further, I note that more background detail about the company can be found on the company's investor relations website and in the most recent investor presentation:
The long case for RF has several tenets:
First, RF has a highly attractive franchise. One of the country's largest banks in terms of assets, RF is one of the biggest banks based in the southeastern U.S. (along with BB&T and SunTrust). Though the area has been hard hit by the downturn, especially Florida, the southeast's population and economic growth has outpaced much of the rest of the country in recent years, driven by an inflow of people seeking a cheaper lifestyle, lower taxes, jobs at companies expanding in less unionized states and, obviously, better weather. While migration and economic activity are cyclical, I like the long-term potential that the southeast offers, which should buoy RF's results over time. Beyond the big picture, the more practical foundation of RF's franchise is the company's vast low-cost deposit base. RF has leading, relatively dense deposit market share in most of the states in which it operates, including #1 market share positions in Alabama, Tennessee and Mississippi. RF also has significant deposit share in other states: it's #4 in Florida, #3 in Louisiana, #6 in Georgia and #2 in Arkansas. On a weighted average deposit market share basis, Regions ranks #4 in the country and is the leading regional bank measured by this metric. This positioning gives RF access to a sticky, low cost source of funds that is one of the few differentiating factors in banking, since much of what happens on the asset side of a bank's balance sheet is commoditized. The economic benefit of such a deposit base is unfortunately less evident during periods of extremely low interest rates. During periods of higher absolute rates and/or a steeper yield curve, however, the benefit is significant. Furthermore, my view is that a major driver of a bank's M&A appeal is its deposit franchise, given the difficulty, expense and time required in penetrating a new market from scratch. In more normal times, RF's deposit franchise should therefore be a source of attraction, rather than a variable the market appears to care little about at the moment.
Second, I believe RF's credit exposure is manageable, even in an economic downturn. For context, the reason RF has suffered mightily since 2007 is that the bank got over its skis on commercial lending in the southeast, particularly to residential development projects in Florida and along the rest of the gulf coast. The company took significant losses on these and other loans, leaving RF with a weakened capital position. That's the bad news. The good news is that while management committed a variety of development-related lending sins, they at least avoided falling into the trap of many other now failed banks in the southeast, such as buying brokered home equity or other syndicated loans, or relying on unstable brokered deposits to fund real estate loans. Moreover, management at least stayed within the bank's geographic footprint with its lending activities, another kiss of death in the last crisis. While this is cold comfort given the severe downturn in the southeast (Florida in particular), it at least highlights a company that made understandable, not unjustifiable mistakes. Nearly all of RF's pre-crisis management has still been fired, which I would also put in the "good news" category. So where does RF stand today in terms of credit exposure? For the most part, RF's exposures are straightforward. The bank has little to no exposure in the topical high risk buckets: MBS/mortgage put-backs, mortgage servicing/foreclosures (RF's foreclosure proceedings relate solely to the bank's on-balance sheet mortgage loans) and sovereign credit/anything having to do with Europe. Even issues relating to RF's broker-dealer subsidiary Morgan Keegan have been settled. This means that RF's current credit exposures fall into more traditional lending buckets (e.g. C&I, CRE, residential mortgage, home equity, etc), and are thus much easier to handicap from a loss perspective. Importantly, the company has used the last several years to significantly deleverage its balance sheet and reduce exposures to high severity loan buckets like condo and other residential development lending. Put simply, RF is running out of raw material for bad loans. Using Q3-08 balances as a starting point, RF's exposure to non-owner occupied construction loans, which have the highest loss content by far, has dropped nearly 85%, from $9.6 billion to $1.6 billion. The following comparison shows how RF's balance sheet has changed since Q1-09, which was the last quarter prior to the government-mandated stress tests and forced recapitalizations:
Total Assets -8%
Construction Loans -78%
CRE Loans -15%
Loan Reserves +66%
Free Deposits +41%
Tangible BV +2%
The critical reserves-to-loans metric now stands at just under 4.0%, while tangible common equity is currently 6.0% of assets. This is a considerable cushion for a relatively seasoned loan portfolio this deep into the cycle.
Third, RF is significantly under-earning. Regions' EPS have been straddling zero for the last several quarters, which is not terribly inspiring. Of course, these figures have been pressured by a variety of factors that are obscuring earnings power. Most notably, loan loss provisions remain unsustainably high. This is partly a function of management not jumping the gun by releasing reserves prematurely, unlike many peers (Keycorp's negative provisioning anyone?). Other credit-related costs, including unusually high FDIC expenses also remain elevated. From a top line perspective, low absolute rates are pressuring net interest margins (3.05% in Q2-11 vs. a long-term pre-crisis historical average of over 4.00%), while slack loan demand creates challenges in growing the balance sheet. New regulatory compliance costs that have yet to be fully passed along to customers (e.g. Durbin debit fee limits) are a further headwind. I believe that normalized EPS range from roughly 85c to $1.40 in a steady state scenario (i.e. keep Morgan Keegan, keep TARP) and approximately 80c to $1.35 in a pro forma case that includes the sale of Morgan Keegan and a debt and equity raise to repay TARP. Interestingly, I think the much of the improvement required to get RF to at least the bottom end of that range is from "self help" opportunities, or things that are largely within management's control. To summarize the EPS bridge:
PPNR Run Rate (Q2-11) $2,000
CD Funding Re-price 85
Operating Cost Reduction (1) 390
Credit Card Portfolio (2) 60
Durbin Impact, net (25)
New FDIC Assessments (50)
Adjusted PPNR 2,460
Provision (3) (500)
TARP Dividends (175)
Net Income 1,100
(1) Of which $350m is from lower credit-related costs (exclusive of loan loss provisioning) and $40m is from general operating cost reductions.
(2) Recently purchased from BofA; roughly $1.2b portfolio earning a 5% pretax margin.
(3) Assumes 60 bps on current loan balance of roughly $82b; long-term historical average is <40 bps.
The scenario outlined above essentially envisions a world in which credit quality continues to normalize, resulting in reductions to provisioning and other credit-related costs, but that overall economic conditions remain stagnant, i.e. no loan growth, no fee growth, etc. Sensitivities are easy to run, with modest upside cases in terms of loan growth and NIM producing significantly higher earnings. A bull case with $130b in average earning assets (currently $115b) and NIM of 3.40% (currently 3.05%) produces EPS of roughly $1.40. Not bad for a stock trading under $4.00 per share.
Depending on one's assumptions, a sale of Morgan Keegan and a corresponding debt and equity raise to repay TARP reduces earnings power modestly, probably in the 5-10c per share range. I believe investors would react favorably to the removal of the TARP overhang, in addition to the further strengthening of RF's capital position from a presumed equity raise, despite the loss of some earnings power.
Finally, valuation is attractive and sentiment is terrible. RF currently trades for 60% of current tangible book value, a discount that suggests significant additional losses are forthcoming, a view that I think is overly pessimistic unless the economy goes off a cliff. On a normalized earnings basis, which I think is the more appropriate ways to value RF given that the credit situation is under control, the stock trades at about 4x my low case EPS estimate. This figure suggests that (a) investors are brutally over-discounting future bank earnings, (b) I'm smoking crack with my estimates despite relatively mundane assumptions, or (c) some combination of the two. Obviously RF's current valuation includes no speculation of a take-out, or much of anything else positive happening. From a sentiment perspective, it doesn't get much worse. To start, the banking sector in general is loathed. RF in particular is despised by a variety of market participants. Not that skepticism is unwarranted, but on conference calls investors tear into management with sometimes dubious, probably self-serving short selling-biased riffs, and nearly any action by the company is immediately ascribed to regulatory intervention (e.g. firing of the company's risk manager in last fall, the decision to sell Morgan Keegan). Meanwhile, of the twenty-five Street analysts who cover the name, three have buys, three have sells and nineteen have holds. In a remarkable show of stock recommendation courage, this distribution has been virtually unchanged since 2009. Sentiment has not been much affected by recent insider activity, in which a number of mid-level executives have bought shares. While this is encouraging for the long case in itself, it's notable as well because senior management is presumably blacked out right from buying while the Morgan Keegan process unfolds.
The risks here are fairly obvious. A sharp double dip in the economy, further adverse regulatory changes from Congress or the banking industry's friendly regulatory overlords, and/or a new crisis in home equity loans are just a few potential risks. It's also quite possible that investors decide that bank earnings are permanently unreliable and that tangible book is the only metric for valuation - and to this no premium will be applied. Ever. This would contradict decades of bank valuation history, but certainly seems to be the order of the day. To the extent one likes RF but hates banks, a hedged trade is easy and can be configured in any number of ways (by geography, market cap, perceived level of stress, etc).