Description

I am recommending for the second time in 10 months, WTNY, the largest independent bank in New Orleans and Louisiana. Since my post-Katrina September recommendation, the stock has done reasonably well (up 22%), although not nearly as well as current darling Hancock Holding (HBHC, up 60%), a peer based down the road in Gulf Port, Mississippi. In addition to a 3%+ dividend, I think the stock has 20% upside in the next six months and 40%+ upside within twelve. Why?

 

• As with Q4/05 and Q1/06, I think earnings for the next several quarters will significantly beat consensus: $0.63 in Q2/06, 9% ahead of the current $0.58 consensus; $0.67 in Q3/06, 16% ahead of consensus $0.58; and $0.70 in Q4, which sets them up for at least $2.85 of EPS in 2007, 16% ahead of the current $2.45 consensus. My upside comes from a rising net interest margin (vs. the compression that much of the sell-side expects), which I explain in further detail in the table below.
  
  
• Despite what is shown on CNN, problem loans are not a concern. WTNY has been conducting an exhaustive review of its loan book and results through May are very encouraging. I am anticipating a fairly definitive statement with the announcement of second quarter results.
  
  
• WTNY could see another surge in deposits in late 2006 and 2007 as $6.2B+ in federal “block grant” money for Louisiana is distributed. HBHC has been rising on news of federal grants for Mississippi. It is inconceivable that HBHC would benefit from this while WTNY would not.

 

WTNY’s Balance Sheet Will Drive Earnings Growth

 

Despite significantly beating estimates in Q1 and a stabilization of credit quality, the Street was luke-warm on the quarter because its net interest margin contracted slightly. This completely misses the point because WTNY’s actual net interest revenue increased at a 25% annual rate on higher volume. And importantly, the increase in volume wasn’t driven by risky loans but by the surge in insurance deposits which were subsequently invested in ultra-safe and liquid fed funds. And because the yield on fed funds (5.25% and rising) is now higher than the yield on the longer term bond portfolios of most banks, including WTNY (4% to 5% and not rising), that will quickly translate into an improving net interest margin (with lower risk) for WTNY. Many on the sell-side are predicting margin compression throughout 2006.

 

The table below is key to understanding why WTNY’s balance sheet is well positioned for rising interest rates and why WTNY’s earnings will be much stronger than expected for the next couple of quarters. As you can see, the net interest margin declined one basis point from 5.03% in Q4/05 to 5.02% in Q1/06, but net interest income rose from $108M to $115M on a larger base of interest earning assets (average balance of $9.2B vs. $8.5B) driven by the flood of insurance deposits. For Q2/06, I have extrapolated very similar trends within the individual balance sheet line items to those that occurred in Q1/06. (i.e. the rate on savings deposits increases 10 basis points to 1.10%.) Please note that the table below is based on average balances through each of the quarters, not period end balances. The estimated growth for Q2/06 average earning assets is based on the March 31^st period end balance of $9.518B. i.e. I am anticipating no growth in the balance sheet throughout Q2, although there could be more insurance deposits that trickle in and the company has indicated that their loan pipeline is as full as it has ever been. (However, loan repayments will also likely remain high.)

 

ASSETS-Average Balance		Q4/05				Q1/06				Q2/06E
Avg. Bal. for Period		Balance	Int.	Rate (%)		Balance	Int.	Rate (%)		Balance	Int.	Rate (%)
Loans		6,566	111	6.72		6,545	114	7.05		6,500	119	7.33
Investment securities		1,670	18	4.37		1,701	19	4.46		1,700	19	4.55
Short term investments		288	3	4.08		1,003	11	4.37		1,275	15	4.85
Total earning assets		8,525	132	6.17		9,249	143	6.28		9,475	154	6.50
% of Total
Loans		77.0%				70.8%				68.6%
Investment securities		19.6%				18.4%				17.9%
Short term investments		3.4%				10.8%				13.5%
Total earning assets		100.0%				100.0%				100.0%
Deposits and Funding
NOW account deposits		972	1	0.55		1,091	2	0.58		1,200	2	0.61
Money market deposits		1,134	3	1.22		1,108	4	1.56		1,121	5	1.85
Savings deposits		971	2	0.90		1,183	3	1.00		1,235	3	1.10
CD's		722	4	2.12		717	4	2.51		840	6	2.90
Jumbo CD's		1,219	10	3.19		1,252	11	3.59		1,300	13	3.99
Short-term borrowings		508	4	3.01		532	4	3.42		525	5	3.84
Non-Interest deposits		2,955				3,191				3,050
Total Funding		8,482	25	1.16		9,074	28	1.27		9,271	34	1.48
Equity (zero cost)		953		0.00		975		0.00		1,002		0.00
Net interest income			108				115				120
Net interest spread				5.01				5.01				5.02
Net interest margin				5.03			5.02					5.04
Dep. as % of total
NOW account deposits		11.5%		0.55		12.0%		0.58		12.9%		0.61
Money market deposits		13.4%		1.22		12.2%		1.56		12.1%		1.85
Savings deposits		11.5%		0.90		13.0%		1.00		13.3%		1.10
CD's		8.5%		2.12		7.9%		2.51		9.1%		2.90
Jumbo CD's		14.4%		3.19		13.8%		3.59		14.0%		4.00
Short-term borrowings		6.0%		3.01		5.9%		3.42		5.7%		3.85
Non-Interest deposits		34.8%				35.2%		0.00		32.9%

 

The one line item where I am likely most different (or where the sell-side hasn’t bothered to look) is on the interest rate earned on WTNY’s short term investments, which has become an important part of the story as these now make up almost 14% of WTNY’s total interest earning assets vs. only 3% in Q4/05. Most banks usually hold less than 5% of their earning assets in such securities because they are generally low yielding. Most of the sell-side is likely assuming that these will earn a similar rate to its longer maturity “investment securities” which will likely earn around 4.55% in Q2. This is because most banks’ “securities portfolios” have a maturity/duration of 3+ years, meaning that they respond slowly to changes in interest rates. Because of the hurricane deposits, however, WTNY is unique in that a substantial amount of its portfolio is short-term and will quickly reprice higher in this rising rate environment. That is why I am projecting they earn 4.85% in Q2/05, ahead of the 4.55% that the longer maturity portfolio will earn. (4.85% is the weighted average Fed funds rate throughout the second quarter.)

 

Combine this with a deposit/funding base of which 35% is non-interest bearing deposits and another 37% is low interest NOW, money market and savings deposits, and the result is a balance sheet ideally positioned for a rising interest rate environment. This is why I think the net interest margin will expand two basis points in Q2/06, although I think my estimate has a lot of conservatism baked into it. (i.e. I have non-interest bearing deposits declining to 33% of total deposits down from 35% in the prior two quarters as well as no balance sheet growth on a period-end basis.) My modeling leads me to $120M in net interest income for Q2, $5M ahead of Q1, which translates to roughly $0.05 of EPS. Because WTNY has all of its deposit gathering infrastructure in place and the earnings are being driven by re-pricing dynamics rather than any new sales efforts, I do not think the sell side appreciates how high the incremental profit margins are on these new deposits. The same re-pricing dynamics should add another $0.05 of EPS to Q3 and another $0.03 to Q4. Additionally, WTNY has been running at elevated expense levels as a result of the hurricane (i.e. housing some employees in hotels). A more normal run-rate could easily add $0.01-$0.02 of EPS per quarter.

 

As I noted above, 2007 could be very interesting because of the federal block grant money. Beyond 2007, we have a bank that will likely be heavily involved with the reconstruction of the Gulf South coast (driven by the Gulf Opportunity Zone, which provides federal tax incentives for up to five years) as well as continuing its profitable expansion into Florida and Texas. This bank has a bright future.

 

Credit Quality Is Not An Issue

For the last 10 months, WTNY has been conducting an exhaustive review for potential problems in its loan book, beginning with the largest credits and relationships first. This special review was well on its way to being done by the end of March and now should be substantially complete. Management indicated at a conference in May that the review had continued to yield little new development in bad loans. As a reminder, since Katrina, WTNY took a special $34M provision for loan losses in Q3/05 (yet still reported positive EPS of $0.14) and reported $0 and $2M in the following two quarters. It has also seen bad loans rise from $19M pre-Katrina to $44M in September to $66M in December and $66M again in March. Cumulative net charge offs in the last three quarters have been only $5.4M on a total loan book of $6.4B. Additionally, WTNY’s level of “criticized assets”—an internal and broader measure of loans with potential problems— actually declined by $17M from Q4 to Q1. This is a very bullish signal indicating that future development of bad loans is unlikely. While it is hard to reconcile this amazing result with the desperate images from CNN, this is consistent with WTNY’s operating philosophy: sourcing deposits in New Orleans and Louisiana and investing them in loans in Texas and Florida and places where there is higher economic growth. WTNY is also a commercial lender, with very little devoted to residential housing, which is what we primarily see on CNN. Finally, many businesses carry property insurance, which provides WTNY’s collateral with extra protection and means the recovery rates on its current bad loans will also be higher. Overall, I think the reduced risk profile adds 1 to 3 PE multiple points to the valuation over the next year.

 

Potential Second Surge in Deposits in 2007

To clarify, the $1.5B surge in WTNY’s deposits over the last three quarters ($7.2B to $8.7B) was the result of insurance proceeds and charity donations as well as some initial emergency FEMA spending. What is now coming down the pipeline is federal block grant money for the areas ravaged by the hurricanes: it amounts to roughly $6B for Mississippi (which is definitely ahead of the curve, in part because all of the major politicians are prominent Republicans—Senators Trent Lott and Thad Cochran, and Governor Haley Barbour), and $6.2B for Louisiana (plus another potential $4.2B for LA if the politicians get their act together). This money has not yet been distributed to the states or hit the banking/deposit system. (It is only just starting to hit Mississippi now, which is why investors have been bidding up HBHC.) This is a large amount of money and WTNY could conceivably take in another $1 billion in low cost deposits over the next year or so. I anticipate this could add as much as $0.30 in annualized EPS to my initial $2.85 estimate for 2007. That would put earnings at $3.15, putting the forward PE at only 11 times vs. peers such as TRMK and BXS (both mediocre and both based in Mississippi) at 14+ times and Hancock at 18+ times.

 

 

Other Noteworthy Points

 

• WTNY did close its acquisition of Florida-based FNB on April 13. This will make the organic trends more confusing to figure out, but the deal should add about $380M in assets, $280M in loans, and cause about $0.01 of integration related charges. My table above excludes the effect of the deal.
  
  
• WTNY will likely NOT sell in the next couple of years, as I had suspected earlier this year. The board is actively looking for a successor to the current CEO, 63 year old Bill Marks. I bet it will be William Baird, the current 54 year old commercial lending chief. An announcement will likely be made before the end of the year.

 

• WTNY will also continue to be the beneficiary of M&A dislocation within the banking industry. We are coming up shortly on the one year anniversary of Capital One and Hibernia, which used to be the largest independent bank based in Louisiana. I suspect many key employees with one-year lock-ups will be very interested in joining WTNY’s more pure-play commercial banking operations rather than being part of a lumbering conglomerate. Most recently, AmSouth and Regions Financial, two large Birmingham banks with extensive operations throughout the Southeast, decided to merge. This deal will almost certainly destroy value and cause some key employees to defect to local competitors, of which WTNY is of course one. And just a couple of weeks ago, BBVA, a large Spanish bank with a big presence in Mexico, announced that it was acquiring two Texas banks, each for about 20 times forward year earnings. (WTNY has sizeable operations in Houston.) M&A activity in the region is very good for valuations of small and mid-cap banks.

 

• Because of its deep historical roots in New Orleans, WTNY also has interests in certain oil and gas properties, the value of which that it hasn’t had to disclose because of grandfather laws. It periodically sells some of these assets off, realizing small gains of roughly $1-2M. While the dramatic growth of the banking operations in the last decade has minimized their relative importance, they can only provide upside in these days of $70 oil. (These assets were suspected to be so valuable back in the 1980s that some hostile investors unsuccessfully tried to take over WTNY to obtain them.)

 

• It is also worth repeating that WTNY is no longer exclusively a New Orleans or Louisiana bank. About ten years ago, it began a successful expansion into Florida and Texas, which now make up about 25% of the franchise. These are fast growing markets where banks trade at 15+ current year PEs.

 

Major Bear Points

 

• Despite a record pipeline of new loans, loans on the balance sheet could decline slightly for the next quarter or two as loan repayments remain at very high levels due to all the insurance money. This should be ignored. Given WTNY’s attractive franchise stretching from Houston across the Florida panhandle, it will eventually have ample opportunity to deploy loans. The oil boom is generating tons of economic activity in Texas and the Gulf and baby-boomers still want to move south and be close to the water. The Gulf Opportunity Zone also will encourage loan development throughout the region.

 

• Even when WTNY demonstrates good trends in asset quality, sell side analysts will likely hem and haw. We have heard that the investment committee of one sell-side firm wouldn’t allow the analyst to upgrade the stock given the risk the recommendation would pose to their retail client base if New Orleans is hit with another hurricane. You can’t make this up. First, hurricanes have clearly proven to be positives for banks--“transfers of wealth from insurance companies to banks” as one colleague says. Second, WTNY’s special loan review is looking to identify not only loans with current problems but also loans that might encounter future problems, for instance, that were relying on FEMA or insurance money for cash flow.
  
  
• Deposit customers will demand higher yields on their loans. WTNY will probably see this to some extent, as all banks will, which I have modeled for, but it must be noted that the New Orleans banking market, because of the corruption and stagnant economic growth, has far fewer competitors than most banks. i.e. a  CBH operating in New Jersey, Manhattan, Washington D.C., and Florida. At least in Louisiana, where the majority of its new insurance deposits are based, WTNY will likely be able to maintain favorable deposit pricing for the foreseeable future.
  
  
• Political divisiveness in New Orleans and Louisiana. This is slowing the planning and redevelopment efforts, but WTNY has operations that extend well beyond Louisiana. I also am optimistic that with the knowledge that many eyes are watching, the politicians will step up and do the right things. In the meantime, WTNY’s earnings growth for the next several quarters will be somewhat automatic.

 

Valuation

At $35 per share, WTNY trades at 13.6 times my 2006 EPS, 12.3 times 2007, and 2.9 times tangible book value on which it is currently earning a very healthy and sustainable 21% ROE and 1.60% ROA. This is a stock that previously traded at 17 times current year earnings. Some relevant peers include TRMK and BXS, two mediocre banks based in non-coastal Mississippi, which trade at 14.0 and 14.7 times 2007 EPS. Looking at the relative stability of WTNY’s stock chart over the last 4 months, particularly compared to HBHC, which is over 18 times 2007 EPS, I doubt the earnings surprise is priced into the stock. I think the stock trades to at least to $42 within 6 months, implying 20% upside. With a little luck, I think the stock gets to $50 within a year, or up over 40%. In the meantime, we have a 3%+ dividend yield to reward us. One more reason why I like holding WTNY in this turbulent market is its interest rate sensitivity. Without a doubt, further Fed rate increases are a significant positive for WTNY’s bottom line.

 

Catalyst

Q2/06 and Q3/06 earnings beat on rising margin

Stable to improving credit quality; favorable update on conclusion of special loan review process

Second surge of deposits in 2007 from federal block grant money

Fallout from Hibernia-Capital One deal and AmSouth-Regions merger

Asset sensitive-- higher earnings with each Fed rate increase.