|Shares Out. (in M):||90||P/E||16.5||12.5|
|Market Cap (in $M):||3,850||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
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For all the obvious reasons I am not a huge fan of banks, but this one is a real exception. Bank of the Ozarks is a bank that I actually like a lot and one that I think offers a very low-risk but high-return opportunity, that is unique in the banking sector. If one is willing to give this investment enough time it has the potential to be worth multiple times its current price and will likely compound at rates over 15% p.a. for a long time. My guess is it will deliver between 18-22% p.a.
When it comes to investment tastes, just like my general distaste for banks, I have a soft spot for outstanding mangers and this is really what draws me to this idea. The investment case in Bank of the Ozarks rest on the giant shoulders of the man who has built this outstanding business, literally from scratch to soon over $17b in assets. Of course we all know growth alone is not desirable and certainly not unique, but achieving that kind of growth while generating >20% p.a. along the way + outperforming your peers in all important KPIs + never losing money in a single quarter over a period of 37 years truly is.
I will keep the idea relatively short, mostly because I think it is straight forward and easy to grasp, but also because I have not a lot more to say about the gernal thesis. Third, while being long Bank of the Ozarks I am currently an equal or greater amount short Time... Nonetheless, I did my homework on this and I have good confidence that it will play out well. If you think otherwise let me know and challenge my thinking.
The current/recent bear market in financials has created an attractive entry point again. None of the issues that have caused the sell-off, be it the recent macro/EM weakness, the oil & gas distress or the China-induced general commodity bear market, pose a risk to this bank. In fact, a normal recession might even help returns. For example, the oil and gas distress is already helping. After 3 quiet lending years in crowded Texas, the bank is now back and real busy in the state, because the eager comps have pulled back. According to them, they really get good deals there at the moment. Apart from that, I view potential rate hikes, slow or fast, only as gravy on top. In my opinion, this bank doesn’t need higher rates to deliver more than satisfactory returns to its shareholders.
With the currently known and almost assured future growth - there are 2 pending acquisitions, and a lot of not yet funded but closed organic loan growth to come - one is able to buy this highly attractive business for roughly 12-13 x 2017 earnings.
What are we dealing with?
Bank of the Ozarks is a community bank headquartered in Little Rock, Arkansas. The current chapter of the Bank started 1979, when current CEO and Chairman George Gleason took control of the bank. At the time, the bank had 2 offices, $28m in assets and 28 employees including George Gleason, who was 25 year old back then and had no prior banking experience. However, George Gleason was brought up in quite an unusual but very beneficial way to succeed in business. Apart from that, I think it is more than fair to say that he was and still is a particular gifted and enormously driven person. I leave no room for the “Halo Effect” when it comes to his success. He had no head start and banking is a mature and competitive business. One can learn a lot about him be reading this interview. http://www.bankozarks.com/assets/docs/Gleason_AB2010.pdf
Today, 37 years later, the bank has more than 300 times more assets and wrecks its competition on all important performance metrics. It achieved a ROAA > 2% in all of the last 6 years and has been named the top performing bank in the nation by multiple industry sources for several years now. If you go and look for other US Banks with ROAAs over 2% good luck, you won’t find many…
How is Bank of the Ozarks so profitable?
The bank really focuses and maximises 3 important metrics - net interest margin, net charge-off ratio and efficiency ratio - to achieve these results. Each metric is currently roughly an astonishing 60% better than the industry average. So they really beat the hell out of their competition.
Its main source of revenue, the net interest margin, sits at roughly 5% while the industry’s average is at roughly 3%. When it comes to net charge-offs, the bar stands at only 38% of the industry average over a period of no less than 15 years and has been below the industry average in every year since the company went public in 1997. Lastly, the bank’s efficiency ratio stood at 38% (35% adjusted) in 2015, while the industry average sits at around 60%. In George Gleason’s world it sounds like it is only a matter of time until they reach their sub 30% target. In other words he is confident to be able to operate at less than half the costs of its peers at some point in the next couple of years. While thinking about that number, I really like the beauty of this chart.
Apart from an outstanding risk assessment and a very disciplined countercyclical & opportunistic investment approach, which for example led to investments like boat loads of tax exempt munis at 70c on the dollar in 2009, or 13 closed acquisitions since 2010 with every single one being immediately accretive to book, tangible book and EPS, the bank’s secret success formula to achieve its outstanding loan metrics rests on its commercial real estate lending. Most of the bank’s loan book consists of loans originated by a special real estate group that started its operations in 2003. This group is solely dedicated to this sector and does business not only in states where it takes in deposits, but across the whole US. This leads to a better diversified book and enables the bank to shift the mix based on the relative attractiveness of different markets. At the moment they find more than enough loans to achieve a super conservative loan to cost ratio of 50% while still getting a total net interest margin of roughly 5% and a 80% variable rate book that sits at floor rates but would immediately lift off with a few rate hikes. The real estate group only approves around 6-8% of the deals they receive/look at. Apparently all the stuff that gets to the desks but fits the standard boxes of the big banks, gets directly tossed away. According to Gleason the group has generated a total write off of $13m since 2003. I find this amazing…
The unfunded but already closed loan pipeline currently stands at $5.8b with $2.8b growth achieved in 2015. Due to the currently very prudent stance, the group focuses on deals where funding happens late/last but the risk is lower because there is a lot of equity above them. As a result, the bank currenlty certainly leaves some profitability on the table, but I like it. Apart from the prudence in real estate lending, the bond book is on hold until they we get more attractive times again. The financial crisis showed that Bank of the Ozarks walks its talk. I am certain they would quickly increase the book if the right opportunities present themselves.
Besides its strong core capabilities, the bank has built up a best in class acquisition team over the last couple of years. The 13 closed acquisitions since 2010 show how well they are executing this strategy. However, since it was primarily done with shares, it comes with a slight catch, a relative currency gap and a strong synergy potential are needed to continue to play this successfully going forward. They are still highly focused on this area. According to Gleason, they have already looked at close to 300 potential transactions. With a deposit market share of only 1% in its seven current operating states and still close to over 6,000 different banks in the US, the potential is simply vast. The organic growth also continues to be highly attractive, organic core checking accounts continue to grow nicely.
I think the environment for ongoing consolidation and the potential to put equity to work at Gleason’s target returns of around 20% will continue to be favourable for a long time and the 2 pending acquisitions high likely won’t be the last. Even though the bank has already grown by an astonishing factor under George Gleason’s leadership, I currently see no limit on the horizon.
What is one currently paying for this gem?
I keep it simple. First, I take a share count of 120m. This is close to the worst case in terms of dilution from the 2 soon to be closed acquisitions. The bank’s assets will swell to around $17b via the acquisitions, organic growth of $3b (guidance, well backed by the unfunded loan balances) will put the asset balance to around $20b at year end 2016. Without another acquisition, organic growth will likely bring in $4b in assets in 2017 take the average assets for the year to $22b. Next, I simply assume a ROAA of 2%. If they continue to be so conservative the net interest margin has room to fall, but so has the efficiency ratio. So I think on balance around 2% is reasonable and with that, they will be able to get to an EPS of around $3.5. If I am off with my assumptions I think it won’t be a tragedy because ongoing growth shouldn’t push this EPS number far into the future. Apart from that a P/E of 12-13 for this business would certainly be too cheap in my world. Anyway, I think one should buy this business not for next year’s earnings but for its 2020 earnings potential.
I have attached recent comments by George Gleason from the Raymond James Inst. Conf. from early March. I think it contains a lot of valuable information, addresses some risks and nicely describes the operations.
Comment on regulation and loan portfolio concentration:
Okay. Happy to answer that. We are a commercial real estate lender. The vast majority of our loan portfolio is in real estate. The vast majority of the real estate segments of our portfolio are commercial real estate, construction and development loans. It's what we do, it's what we've done for many, many years and we think we do it better than anybody else in the industry.
Our net charge-off ratios and our experience suggest that that is in fact the case. When the federal regulatory guidelines on construction and development lending were issued – CRE lending were issued in, I think it was the fourth quarter of 2006, we read those guidelines and we were way over the guidelines on both metrics. So clearly, we were keenly interested in that and we read them again and again and what I told our staff at that time in early 2007 is, you know we are doing all of the things that the regulators require you to do if you have a CRE concentration. The guidelines – our guidelines, they are not hard and fast limitations, but the guidelines say, if you have a concentration in total CRE or construction and development loans, you need to do a bunch of things proactively to measure, monitor, and manage your CRE concentration. So we were actually slightly higher on both metrics at June 30, 2007 than we were today.
When we went through our examination in the third quarter of 2007, our examiners came in and said, CRE is going to be a focus of this examination. We've issued new guidelines for pulling a disproportionately large part of your CRE loans for review, yadi yadi yada. And we went through the exam and at the conclusion of the exam, the examiners had no downgrades in any of our risk ratings on loans, they had no technical exception page in our exam report, they were very complimentary about the job we were doing and they simply said that our processes for measuring, monitoring and managing our CRE concentration were very robust, and keep doing it. And we have continued to have very positive regulatory response to our business model over the ensuing nine years.
That should be very evident from the fact that during the downturn years of 2008, 2009, 2010 and 2011, there was not one day that we were not taking new applications for land loans; there was not one day that we were not considering new applications for commercial lot development loans or residential lot development loans; there was not one day that we weren't doing spec and pre-sell residential construction; there was not one day that we were not looking at new loans on offices, shopping centres, warehouses, industrial, condos, apartments; there was not a single day that we were not doing business actively and in a property tab.
And we were able to do that even though we had a above the concentration guideline level throughout that period of time as we do today because we do a very good job monitoring, measuring, managing our CRE concentration risk and we have a very high quality portfolio. And again, that's evidenced in the fact that our historical charge-off ratios have been 38% of the industry average charge-off ratio. So my take on this – the regulators reissued essentially the same guidelines a few quarters ago. Our take on this is that the regulators are focused on this as they should be and that that focus is as it always has been. If you are doing a really good job doing what you are doing and you are doing an effective job of managing, measuring, and monitoring those concentrations, then I think that's what the regulators want; and if you are not, then I think you can expect some pushback from the regulators.
So we think we are doing an outstanding job with this. And clearly, if you look at our asset quality ratios, at December 31, our ratio of non-performing loans and leases to total loans, our ratio of non-performing assets to total assets were not below as we've had at any quarter end, but they were the lowest since the third quarter of 2007 and that was either the first or second-lowest in the history of our company at that time. Our past due ratio at December 31 was the lowest quarterly past due ratio we've had in any of our 19 years as public company. Our non-performing loan's very, very low. So we feel like our portfolio is in absolutely fabulous shape and don't expect any regulatory pushback on that other than just the normal enquiry, are you doing what you need to do to measure, monitor and manage your CRE concentration. The majority of our construction and development loans and CRE loans for that matter are originated by a specialized group called Real Estate Specialties Group. We created this unit in Dallas, Texas in 2003. We built it from scratch. It is really designed to be the ultimate commercial real estate lending platform in any bank in the country. And I'll give you a bit of a metric on that unit. In the 13 years that that unit has existed – and by the way it accounts for almost 60% of our non-purchased loans. Excluding loans acquired in acquisitions today, it accounts for almost 60% of our portfolio and is almost 90% of the unfunded balance of loans that are closed on our books today, construction loans that are waiting to be funded. That unit, in 13 years of operations with billions and billions of dollars of loans going through, [ph] just (13:40) had two loans that generated losses; both these were in 2009. The charge-offs on those loans were approximately $9 million and change. We did subsequently have an OREO write-down on one of the assets that was transferred to OREO as a result of that. So if you look at that OREO write-down plus charge-offs, we've had $12.4 million of losses in that unit over 13 years. It is the largest unit of our company and that's an 11 basis point annualized charge-off ratio over that 13-year period of time.
So some folks would say, gosh you are heavily focused on CRE and construction and development lending; why don't you have a third of your book in consumer loans, a third of your book in C&I loans and a third of your book in real estate. And my answer is always to that; we don't do consumer and C&I near as well as we do construction and CRE. And if you want my charge-off ratio to look like the industry average charge-off ratio, we can diversify and probably accomplish that. But if you want us to continue to operate with a charge-off ratio that's a fraction of the industry charge-off ratio, we need to do the line of business in which we have the greatest expertise. And I think our results from Real Estate Specialties Group certainly indicate that that is an area of expertise.
The loans we do in that group are very low leverage. I'll give you a metric on this. Again, I've got beautiful slides for all this. Go to our website and look at the slide. But at December 31, our average loan to cost on our construction loans with interest reserves, which is vast majority of our construction book has interest reserves built into the cash stack of the loan was 50% loan to cost. Our average loan-to-appraised-value is 44% loan-to-appraised-value. So we do very low leverage loans, which accounts for – or contributes to the fact that we have had tremendous loss experience in those portfolios in recent years.
Now to put that in perspective, if you go back to the 2005, 2006, 2007 timeframe for that portfolio, our average loan to cost then was somewhere around 72%, again 50% now. So we are 22 points lower loan to cost now than we were going into the last down cycle. And our average loan-to-appraised-value back in that 2005, 2006, 2007 timeframe was about 68% loan to appraisal. We're 44% now, 24 points lower loan-to-appraised-value. As we surveyed the landscape in 2010 – 2009, 2010 and 2011 and we saw that almost all the other large real estate lenders had pretty much exited the business either voluntarily or involuntarily and we were continuing to make loans in every product type every day, and we could afford to do so because our portfolio was holding up so well versus the industry, we tried to really assess the myriad differences in our portfolio and the portfolio of our competitors and we identified a lot of things that we do vastly differently, but one of the clear differentials was, even then we were probably 10, 12, 15 points lower leverage than a lot of our competition and it was pretty easy to see that our lower leverage was a significant contributor to the positive outperformance of our portfolio.
So we said, if 72% loan to cost is getting us this kind of outperformance, what if we got into the high-60s. And in literally just a matter of a few quarters, we got that weighted average loan to cost down in the high-60s. So then we set our sights on the mid-60s, and then the low 60s, and we said, wow, maybe we could get a 50-something handle on this. So over the last seven years, if you saw my beautiful slide on this, you could see an almost linear down-trend in our loan to cost and loan-to-appraised-value. So we feel like our portfolio is the best portfolio today that we've ever had in my 37 years in the business with the best sponsors, the most marquee projects, and the lowest leverage.
Comment on M&A:
Yeah. Your point is exactly right and the implication of your question is, we are not going to buy any banks that have performance metrics like our performance metrics. Totally agreed. We've looked in the last seven years at over 200 banks, probably approaching closer to 300 banks now. And we view every acquisition as a parts job. We're basically buying a franchise that has a lot of parts, and some of those parts are very appealing and desirable and can be unbolted and fit into our company in a very accretive way; some of those parts need some restoration and then they can be fitted into our company in a very accretive way; and some of those parts need to be jettisoned. And we value the parts and [indiscernible] the cost of jettisoning the parts that don't fit, and what we are trying to do is do the transaction in every case that meets four test; we want the acquisition to be accretive on the day we close it to book value per common share; we want the transaction to be accretive on the day we close it to tangible book value per common share; we want the transaction to be accretive to our earnings per share in the first 12 months following acquisition if you ignore day one transaction cost; and we want the resulting company after we've dismembered the parts that we don't want and fixed the parts we do, we want to look at that resulting balance sheet of that residual pieces that we're keeping and believe that we can generate somewhere around an 18% to 22% return on equity on that residual operating piece of the acquired company, assuming we allocate 8.5% tangible common equity to that transaction.
The – we do have two transactions pending right now. The 13 transactions that we have previously closed have all met those performance criteria and thus have all been very accretive to our shareholders in the process. I've never had to stand up and explain how long it was going to take us to recoup our dilution on a translation because we've never had a dilutive transaction. We believe that the two pending transactions will also meet those test.
We paid more for the two pending transactions than we have paid for any previous transactions and that simply reflects the fact that they are better banks than the previous acquisitions we've made; they have much more accretive value and many more useful parts than the previous acquisitions we've made. So if you are going to buy a lot better parts and a lot better franchise that has few parts you want to jettison and many parts you want to keep, you're going to pay a little higher premium for that. So feel very good about those. These transactions we expect to close most likely in April. We – there's a slim possibility that we could get one or both of them tucked into the end of March, but I really think they are April transactions. There is a slight possibility that it could slide to May or June, but we are pretty optimistic we get them done in this April.
Comment on the Real Estate specialty group:
Yes. Absolutely. And what we bring is I think an unparalleled level of expertise and ability to execute for our sponsors. Our sponsors clearly pay us a higher interest rate. They clearly put up with much tougher loan documents from us than our competition. The equity requirements in our transactions are much higher than many of our competitors would offer. So our sponsors are doing business with us because of the relationship and our expertise and ability to execute and create value for them. Now part of that relationship, as a lot of our sponsors realized, well, in 2009, 2010 and 2011 they were the only guys out there making loans, and even if I pay them extra, I want to keep that relationship viable because in the next cycle they are probably going to be the only guys out there making loans again and I want to make sure that I've got a source of capital for my good deals. So that relationship is clearly part of it; quality of service is clearly a part of it, but what really gets us business day in, day out is our ability to execute. We turn down two-thirds to three-fourths of the transactions we look at on the first day. And our pull-through rate in Real Estate Specialties Group is about 6% to 8% of the loans we look at every year. And the loans that we turn down on day one are loans that are – they got to fit the credit boxes of the big banks, and that doesn't mean they are as good as the loans we do, it just means they fit the credit box, the big bank's box credit. If a apartment deal meets these 22 criteria, it's going to get approved and because it fits the box, you are going to get 'X' leverage and 'Y' pricing.
And we are looking for – we turn those deals down typically, because we are looking for transactions where our ability to help the sponsor structure the transaction and accomplish a transaction that has some significant complexity to it is worth them paying us extra for. So we typically – we do business with the vast majority of the largest real estate players in the country; we do business all over the country with them. And we get all of their really [ph] brain damaging and really (25:13) hard complex deals where they need an extraordinary level of expertise in structuring, documenting, closing, and sourcing a transaction all the way through to a successful loan payoff. And if you are just selling money, you are going to have average returns and average credit quality, but if you are selling a valuable relationship that's a long-term relationship and you are selling expertise that is not otherwise very prevalent in the industry and you can do things, solve problems, and accomplish things for your sponsors, then they are willing to pay extra for that and they are willing to are agree to a structure so the transactions that are very helpful to us achieving our much-better-than-average asset quality.
Comment on the Texas worries:
Yes, and you know we love Texas. And I'll tell you this on Texas. During 2009, 2010 and 2011 of course the Texas economy was doing better than just about any other state economy and our Real Estate Specialties Group office is headquartered in Texas and we started that unit out in 2003 focused on probably the 80 of the best real estate developers in Texas or so. So that Texas focus meant that we generated a lot of business in 2009, 2010 and 2011 in Texas. When the other lenders in the country came out of their foxhole and a lot of these guys hadn't made a loan in two years or three years and they came out of the foxhole and said, well, we've got to make loans again, Texas was a beacon for them, because as they looked around, they said, wow, the Texas economy is so much better. So a lot of these guys ran to Texas, and we did not through our Real Estate Specialties Group originate much new business in Texas in 2012, 2013 and 2014, because very simply, there were so many banks trying to make loans that they were putting crazy leverage on things and charging super low rates and we could get much better risk adjusted returns in markets all over the country apart from Texas.
So we just didn't grow much in Texas in 2012, 2013 and 2014. But with the oil and gas crisis last year, a lot of those banks began to exit the market. So we've got a transaction now that we're doing in Houston that we're just thrilled about for one of my major New York sponsors. It's a very big transaction, a multiphase transaction and we are – loan to value, loan to cost we are right around 40% – I can't remember, it's either 42% loan to value, 38% loan to cost or vast for us, I can't remember, but just say, 40% average there between the loan to value, loan to cost on that, so there's 60% cash equity in that transaction. And the transaction's phased in multiple phases and the risk – the least risky phase is done first and you can't get the money for that until he achieves a certain debt service coverage with lease in place on that and you can't get to the next phase until he achieves enough debt service coverage to cover that phase even if he doesn't lease anything in phase 2, and similarly for phase 3 and phase 4.
So because the other banks have gone, we are able to meet our criteria of getting a transaction with an extremely marquee sponsor on an irreplaceable asset super marquee project at very low leverage, 40-ish loan to cost, loan to value with a very defensive loan structure. And I worked over the weekend on a transaction with our Real Estate Specialties Group guys. That's another potential deal we are looking at in Houston; another multiuse project, another very marquee sponsor, a sponsor we've never done business with before that's a very affluent, very successful Texas sponsor. But he's called us on this and we're looking at a 30% loan to cost transaction. And so just as we achieved great growth in 2009, 2010 and 2011 when all the competitors exited the business and we were able to structure very low risk, profitable transactions in that market, similarly, Texas and Houston and Dallas both have become much greater markets of opportunity for us in the last 12 months because a lot of the guys that were doing crazy stuff that kept us out of the market are now gone, so we are able to go in and structure much more sensible projects or structures on great projects and get paid reasonably well for doing so. So we had our Board Meeting in Houston a couple weeks ago. We do two Board Meetings a year out of Arkansas in areas where we have a lot of properties.
Our North Texas guys came down and presented at one session of the Board Meeting. Our South Texas Community Bank guys presented at another session. We took two hour, three hour bus tours of the market, looked at everything we've got in the market. Our Real Estate Specialties Group guys came and had a several hour presentation and went through their 50 largest loans all over the U.S. with the board and we had the Federal Reserve's economist who focuses on Houston come and present to us for an hour-and-a-half or so. And I can tell you we are extremely comfortable with everything we've got in Texas and very optimistic about the fact that as a lot of other lenders have run from the market, that has created a real time of opportunity for us to do some great new business there.
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.
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