Thesis

Customers Bancorp, Inc. (Ticker: CUBI) is an underfollowed, northeast bank, which only listed on a national exchange 15 months ago, trading at 10.5x 2015E EPS and 1.2x TBV, a 21% and 20% discount to peers, respectively. The bank is growing like a weed and comprises Jay Sidhu’s platform to re-create Signature Bank’s low-cost, high-growth business model, which trades at 18x 2015E EPS today (Sidhu and other insiders own 17% of CUBI). Signature went public in 2004 at 1.5x book, earning a low-teens ROE, and investors in the IPO have since made nearly 8x as mgmt has steadily expanded the business, a rarity in bank land. I believe CUBI represents a similar early-stage bank growth opportunity, at a significant discount trading at 1.2x / 10.5x 2015E consensus. I believe the stock today is worth $29.48 or 15x mid-2015 earnings run-rate of $1.97, a 56% premium to the current stock price. Growth stocks are extremely difficult to come by for bank investors, and I believe once CUBI is discovered by the bank investor community, it will trade to a premium valuation to reflect its level of growth.

The first positive catalyst occurred after the close yesterday with CUBI putting out an 8K stating the DOJ has completed its review of alleged CRA infractions without any enforcement action. The most recent company to come out of an investigation is up 26% in the 7 months since making the same announcement. Resolution of the Religare investment overhang, another positive catalyst, should also occur sometime over the next few months.

Overview

Customers Bancorp, Inc. is $5.6bn in asset bank headquartered in Wyomissing, PA. The company operates 15 branches with an impressive $178mm deposits per branch (vs the national median of ~$40mm). The bank provides a full range of banking services to small and medium-sized businesses, professionals, individuals, and families through a branch-lite operating model. The bank currently offers CRE, C&I, mortgage warehouse LOC, and multifamily loans. CUBI expects to reach $9bn in assets by the end of 2019, at which point it will stop growing assets to remain under the Dodd-Frank $10bn asset exemption, and likely pursue a sale of the bank. The bank’s need for equity capital will be limited after a few more years of growth. 

Brief History

CUBI was formerly known as New Century Bank, and was hemorrhaging money coming out of the crisis. Jay Sidhu, former CEO of Sovereign Bank, joined CUBI in May 2009 as Chairman & CEO, and has recapitalized the bank and recruited many of his former colleagues from Sovereign.

2010: acquired three banks

• ISN Bank ($70mm assets) from the FDIC
• USA Bank ($170mm assets) from the FDIC
• Berkshire Bancorp ($85mm assets) in a traditional acquisition

2012: attempted to acquire Acacia Federal Savings and CMS Bancorp

• Deals were terminated in 2013 due to CRA issues

Feb-13: acquired Flagstar Bank’s commercial portfolio and the origination team for the portfolio
May-13: raised $104mm in common at $16.75 (~$15.08 post 10% stock dividend)

• Relisted to NASDAQ from the pink sheets

Jun-13: invested $23mm in Religare Enterprises, Ltd. a financial services company in India
Feb-14: announced its new mobile banking initiative
May-14: declared a 10% stock dividend

Management: With Controversy, Comes Opportunity

The most important aspect of a bank is management so I will spend more time than I normally do on management. CUBI has a controversial CEO and Chairman in Jay Sidhu, 62. I take the view that Sidhu is one of the more talented bankers I have met running a bank under $50bn in assets, let alone under $10bn in assets. I come to this conclusion after: 1) meeting with 10+ business heads, which offered unprovoked insights into Sidhu’s skills as a leader and bank CEO, 2) calls with former employees of Sidhu, 3) getting to know Sidhu over the past few years, and 4) seeing Sidhu and team turn a $250mm money-losing bank into a $5bn+ in asset, high-performing bank in only a few years.

Sidhu has an interesting life story, particularly for a U.S. CEO, and his interview on Building New York with Michael Stoler in January 2014 does a good job showcasing this (http://tinyurl.com/oznje35). And the exposé in American Banker in August of 2013 walks through some of the controversy surrounding Sidhu. Customers Bancorp's Jay Sidhu, Persistent Protagonist. I read through all the Sovereign Bancorp filings from back in the day and all the press coverage I could find for when Relational went activist on Sovereign Bancorp. Relational’s presentation and proxy gives all the dirt you need to know and be able to come to terms with. In fairness, it’s not a pretty read.

There are many reasons I don’t see the controversy at Sovereign foreshadowing issues to come at CUBI:

• Judge his current body of work: Sidhu’s execution at Customers Bancorp has been nothing short of spectacular. Tangible book value is up 75% since the 1Q10 capital raise. He turned a fledgling $267mm in asset unprofitable bank into a $5bn+ high-performing bank with an attractive footprint, a pristine balance sheet, and a deep management team in 5 years. Early investors are sitting on a 2.5x return.
• Sidhu is well aware of the controversy and wants to make sure his legacy is repaired. Spend 10 minutes speaking with him to see how determined he is to exit on top with a clean reputation and more importantly, strong shareholder returns.
• Insiders own 17% of the company so nobody loses more than them by doing something unfriendly to shareholders.
• Sidhu has done everything he said he would do at Customers Bancorp.
• It’s impossible to empire build with the company’s current mandate as stated in its investor presentation: “any book value dilution from any acquisitions must be overcome within 1-2 years”. In reality, there are very few deals, and any of size, that the bank could acquire with such a short earn back period. Further, the bank targets $9bn in assets by the end of 2019 and this will mostly be accomplished through organic growth. In the investor day presentation, the company has a slide even titled “Why Buy Banks When Seasoned Banking Group[s] May Be Recruited?”
• The bank has learned how difficult it is in this regulatory environment to do M&A and determined it’s much cheaper and easier to bring on teams from larger regional banks as evidenced by the 5 teams hired this year.

The bottom-line is an investment in CUBI is an investment in Sidhu and team. I think this is CUBI’s biggest strength today and we’re getting the optionality that they accomplish something great (e.g., SBNY’s success or the mobile banking platform gains traction) for next to nothing. It’s not going to come without a few hiccups along the way but my view is that over the next 3-5 years this is the team you want to invest in, particularly at today’s prices.  

The Banking Model

The bank is focused on a branch lite model with lower overhead costs than peers with extensive branch networks. This is done through a “high touch, high tech” concierge banking strategy where the bankers go to customers’ homes or offices instead of a meeting in the branch. Branches are located in non-prime locations to save on expenses and have significantly more deposits per branch than peers. As a result, the bank spends more on its cost of funds (a temporary phenomenon) but much less on branch operating expenses to generate an all-in cost of funds advantage.

I went to the headquarters in Wyomissing, PA and met with the whole team over the course of a day. I quickly learned the effort to save on unnecessary expenses is tangible. It’s engrained in the firm culture to generate $2 in revenue for every $1 in expenses. There’s no better example than the NYC team, which came out of the high performing Signature Bank (Ticker: SBNY). The team has an office at 99 Park Ave on the 15^th floor, where rent is a fraction of what a branch on the ground level would cost. The focus is on avoiding unnecessary costs associated with the antiquated branch banking model.

Source: Company presentation.

 Source: Company presentations.

The Path to $9bn in Assets and the Doubling of EPS

I created a basic model for CUBI's next several years of growth by applying management's targeted growth and returns. Management has said they are targeting a 1.00%+ ROA and 12%+ ROE in the next 24-36 months, and based on recent performance, I expect them to attain that level of returns. Management recently revised the timing of achieving these targets to 2-3 years from 4-5 years.

The one area I have taken liberties with management's goals is my 2018 timing for $9bn of growth--the rate of growth implied by the 2019 target seems too slow, and management has likely built in a cushion anyway. On the side of conservatism, in order to capitalize the significant portfolio growth that CUBI expects, I've included a $100mm capital raise over the next 18 months, although I do not believe management will execute this until the shares trade to a meaningfully higher level than today's price.

Thus, in 4 years, CUBI's earnings power should more than double versus this year's. Even without multiple expansion, the implied upside from this rate of core earnings growth is significantly greater than nearly most other potential investments in the banking sector. An expansion of CUBI's multiple to an appropriate level, reflecting this great growth outlook, represents additional upside.

 

Source: Company filings.

Asset Generation

Loan growth has been a staggering ~100% CAGR since 2009. While yesterday’s credit underwriting is often tomorrow’s credit losses, the aggressive growth is off a very small base. Loan growth is set to slow down based on the law of large numbers and the bank’s business plan, which calls for assets of $6bn+ by the end of 2014 and $9bn by the end of 2019. The historic credit loss content of the loans it originates has been low. The bank is copying some of the best banks out there for how they generate assets consistently and safely. e.g., TCBI’s warehouse business and SBNY’s commercial business.

CUBI can be near the lowest rate in the market given its cost structure is below that of the large regional banks and even small peers. The bank’s compromise has been on more leniency in prepayment penalties. The company has underwritten loans to many of its former Sovereign customers, poached loan portfolios and loan teams from sleepy banks, and acquired 3 banks along the way. I fully expect growth to slow over the coming years and the bank to emphasize more gain on sale and fee businesses.  

Multifamily loans: $1.8bn portfolio (38% of total); High net worth families targeted with current loans going on at 3 3/8% to 3.5% for five years. CUBI is currently planning to originate and sell multifamily loans given limited excess capital today and its goal to stay below $10bn in assets to avoid the Durbin Amendment.

Warehouse: $1.1bn portfolio (23% of total); mortgage companies with $5-10mm in equity targeted. Becoming de-emphasized as mortgage market remains weak and other loan portfolios grow.

Commercial C&I and Owner-occupied: $898mm portfolio (19% of total); Small business portfolio: targeting companies with <$5mm in revenues, mainly SBA loan private & commercial portfolio: target companies with <$100mm in annual revenues.

Source: Company filings.

Deposits

The mix of deposits is one of the few areas of weakness at CUBI today with only 17% of the deposits DDA at 2Q14, versus CDs at 38%, and money market/savings at 46%. It’s not as bad as it looks given the company is able to match fund the warehouse portfolio with CDs. The bank has done a good job of reducing its cost of deposits, which currently sit at 63bps from 87bps at 2012 and deposits per branch are up to $177m at 2Q14 from $129mm at 2012. The cost of funds for the industry sat at 35bps as of 2Q14 vs 67bps for CUBI so the company still has work to do.  

The bank currently has the luxury of paying a higher price on deposits and remaining price competitive on loans with its branch lite banking model. CUBI is making a strong push to improve its deposit mix and costs further by adding more teams that can attract deposits (a la Signature Bank) and through its mobile banking initiative. The mix of deposits is a work in progress but continues to improve every quarter.

Sources: Company filings and SNL Financial.

Credit

CUBI has strong credit metrics owing to the fact that the majority of its loan book was originated and acquired post the recession and the loans are seemingly high quality, but low yielding, multifamily loans. On originated loans, NPAs to loans stood at just 5bps at 2Q14. Non-covered classifieds to Tier 1 capital and reserves stood at a rock bottom 3.8% at 2Q14.

Sources: Company filings and SNL Financial.

CUBI stacks up well versus two northeast, multifamily loan focused competitors when it comes to credit as well as reserving policy. CUBI’s reserves to loans are 79bps vs SBNY at 98bps and NYCB at 44bps. NPAs/assets are only 27-34bps for the group.

 

Note: As of 2014Q2. Source: Company filings.

Capital

CUBI does not expect to raise any common equity while its stock is trading below peer multiples:

“And I think that Jay had made the point that we will reach a level of about $6 billion to $6.2 billion in terms of total assets at the end of this year. And that we will not do any significant Tier 1 capital additions subsequent through that until we get our stocks traded at a higher premium.” – Robert Wahlman, CFO, 2Q14 Conference Call

Tangible common equity/tangible assets is the lowest ratio right now at 7.3% and regulators don’t like to see the TCE ratio drop below 7% these days. Management stated it will begin selling off multi-family loans to temper growth instead of raise capital at these depressed levels.

Note: As of 2014Q2. Source: Company filings.

Interest Rate Sensitivity

CUBI is currently positioned moderately neutral to slightly positive for a rise in interest rates. Given the current trajectory of the business with business deposits growing quickly and the potential for the mobile banking initiative to provide low cost, sticky deposits, the bank should become significantly more asset sensitive over the next few years.

BankMobile

The company is launching a mobile banking platform to target customers through its Higher One relationship and targeted marketing. The product is set to launch in October and management doesn’t expect to spend more than $5mm on it so the downside is fairly limited. I have no insights into whether this will be successful but there’s a lot of upside if the company creates a good mouse trap. The initiative, if successful, would help decrease the bank’s cost of funds significantly. Management’s goals call for 250K customers, a 1.25% ROA, and a 15%+ ROE on this venture. 

The Overhang

The Department of Justice Referral

On Aug 7, 2013, CUBI received a letter from the Federal Reserve Bank of Philadelphia stating that the bank was being referred to the Department of Justice (DOJ) for the belief that the bank has not complied with certain provisions of the Equal Credit Opportunity Act, Fair Housing Act, and Regulation B with respect to Philadelphia. On Sept 24, 2013, the bank was informed that the DOJ initiated an investigation. The investigation relates to the belief that CUBI committed redlining violations in 2011 and 2012 when it allegedly chose to avoid low income neighborhoods inside Philadelphia proper.

After the close yesterday, the company filed an 8K stating that the DOJ returned the referral back to the Federal Reserve without any enforcement action. This is the positive catalyst we have been waiting for. Beneficial Mutual Bancorp (Ticker: BNCL) has seen its stock rise 26% since it made the same announcement.  The cost of the CRA investigation has been substantial as the bank had to call off the acquisition of Acacia FSB and CMS Bancorp.

Management has taken the steps to rectify any potential issues, including announcing major CRA initiatives in Philadelphia, hiring a CRA Officer, a Director of CRA, Fair and Responsible Banking, and hiring the top financial services lawyers to handle the issue. Current expenses related to this issue are running $1-$1.5mm per quarter or ~$0.18/share pretax. This has clearly been the biggest overhang to the stock.

Religare Enterprises, Ltd

CUBI invested $23.1mm in the common equity of Religare Enterprises, Ltd., a publically traded financial services company in India, in 2Q13. The company originally planned to invest $51mm but received pushback from its U.S. regulators. The rationale for the investment was to open up the India market to CUBI and help Religare apply for a banking license as Religare insiders were required to divest a portion of their stake to meet certain requirements to apply. Religare has yet to receive its banking license in India and CUBI plans to divest its stake if Religare doesn’t receive its license by the end of Q3. I expect there to be clarity on this overhang come early 2015 if not sooner. Regardless, the investment represents only $0.83/share to CUBI and while it may be a wise investment decisions ex-ante, it has been an unnecessary overhang. It likely increased the company’s cost of capital, given I’m sure it scared some investors away, despite how small the investment is in the grand scheme of things.

Valuation

My preferred valuation is figuring out 1) the earnings power of the franchise and what the appropriate multiple for the quality of earnings should be and 2) the value of the company to a strategic acquirer. Since I don’t believe CUBI is a takeout candidate anytime soon, the earnings power is what I use.

The bank should be fully leveraged come mid-2015 at around $6.25bn in assets and earning $1.97/share on a run-rate basis, which comes to about an 88bps ROA. Earnings are growing 15%+ annually thereafter as the bank on-boards new lending teams. Growth banks typically trade at a P/E slightly above their earnings growth rates. Thus, CUBI should trade at least a 15x P/E. At a 15 P/E, CUBI is worth $29.48/share or a 56% premium to the current stock price. When the stock reaches a 15x P/E, investors are, in theory, underwriting a 15% IRR thereafter.  

Historical

I am not a big fan of a historical valuation framework particularly for financial services, a space where the past often does not look remotely like the future. Nevertheless, it’s worth highlighting the potential asymmetry in CUBI’s current valuation. The stock currently sits at 1.2x TBV and the company has a repurchase program in place to buyback “up to 5% of its current outstanding shares at prices not to exceed a 20% premium over the current book value.” Thus, there is likely a floor in the stock slightly lower than where it is trading should the current economic environment persist.  

Note: As of 8/25/2014. Source: SNL Financial.

Peer Analysis

As I stated in the opening, I believe SBNY is the closest comp today given the business model. SBNY is 17x bigger in assets and trades at a healthy 17.8x 2015E EPS and the street currently expects EPS to grow 17% into 2016E. CUBI trades at only 10.4x 2015E EPS and EPS should grow at 15%+ for at least the next few years. The banks that comp closest to CUBI on size and region trade at 13.2x 2015E EPS and grow EPS at ~14% in the out-years.

Note: As of 8/25/2014. Source: SNL Financial.

CUBI trades at P/E multiple lower than slow growth, over-regulated large cap; CUBI trades at 10.4x 2015E EPS vs large caps at 11.3x. Large cap banks are expected to grow 6% in the out-years whereas CUBI should grow in the mid-teens. CUBI trades at a 22% discount on 2015E EPS versus all banks with average daily trading volume (ADTV) greater than $500K. Interestingly, CUBI only trades 1x turn more expensive P/E than Puerto Rico banks

I should caveat the comparative analysis with it comes down to the quality of earnings the company’s generate given banks can makeup whatever earnings they want by taking extra credit or interest rate risk. I come to the conclusion that’s CUBI’s earnings quality is solid and continues to improve as evidenced by higher DDA balances and more focus on northeast multifamily away from volatile mortgage warehouse.

Note: As of 8/25/2014. Median metrics for all. Banks with average daily trading volume (ADTV) of $500K+. 1) EBSB, BPFH, INDB, UBNK, BHLB, BRKL, WASH, WFD, PEOP, BHB, THRD, FRBK, OLBK, CSBK, ESSA, CNOB, PFIS, BMTC, AROW, UVSP, OCFC, FLIC, NFBK, TSC, METR, SNBC, FISI, ORIT, HVB, LBAI, KRNY, EGBN, SASR, DCOM, TBBK, TRST, WSFS, STBA, FFIC, TMP, FCF, STL, CBU, NBTB, NWBI, PFS, and NPBC. 2) JPM, BAC, C, WFC, USB, PNC, COF, BBT, STI, FITB, and RF. 3) BPOP, FBP, and OFG.

Sources: Bloomberg and SNL Financial.

Risks

• Regulatory Risk. Given the bank is already dealing with regulatory issues and had to call off two great transactions as a result, the bank is operating in a position of weakness. If the relationship with regulators becomes contentious, all bets are off.
• CRA. The Federal Reserve continues to let this issue linger.
• Economic. This is stating the obvious.  
• Credit. While the bank is in the markets you want to be in, bad loans can be underwritten anywhere.
• Interest Rate Risk. The bank is not currently interest rate sensitive. Should rates move higher, the bank would not see the benefits that many peers could see.
• Management does something boneheaded. Management has a checkered past. It’s impossible size the potential for this. Given management statement that it will not issue another share of stock while its valuation is below peers, the potential for dilution anytime soon is limited.