Description

Recommendation

Short FFIN with a target price of $18 (3x TBV).  I also recommend pairing this with a long BANF or KBE to hedge rate-cut scenarios.

Background

First Financial Bank Shares (FFIN) is a mid-cap bank with operations dating back to 1890.  It operates in Texas and benefits from the economic and population growth of the state. It has done several tuck-in acquisitions over the last decade.

In 2022, average earnings assets were $12.5B, funded with $7.8B in interest-bearing liabilities, $4.1B in non-interest-bearing deposits, and $1.4B of equity.

Business Quality

FFIN fits the “compounder” profile. See the table below.

• high profitability (15 year average - 1.8% ROA and 14% ROE), 

• low net charge-offs despite oil and gas exposure, 

• high growth (10.1% EPS CAGR over 15 years) 

Furthermore, not only are these metrics better than peers, they are consistent with a limited range over long time periods.  Even during the stressful times of 2008-09, the bank still generated mid-teens ROE and NCO peaked at 36 bps of loans.

Why does this opportunity exist?

The investor base favors earnings growth. But unrealized loss of AFS securities does not impact the income statement, so it was ingored.  What’s more, as AFS securities are marked down (lower denominator), it “improves” ROA and ROE metrics superficially. Therefore, until recently, FFIN trades at a very high premium, in both absolute and relative sense.

Thesis

The collapse of Silicon Valley Bank forces the investor base to focus on balance sheet risks

Investors value FFIN on earnings growth and thus the stock trades on P/E, not P/TBV.  In fact, FFIN traded above 5x TBV after reporting 4Q22 results, when its 35% decline in TBV is publicly known.  Note that management do not host earnings calls so updates are limited.

This all changed last week with the unfortunate collapse of SVB.  Most, if not all investment professionals, now have decent knowledge, or at least are highly aware of duration mismatch and solvency risk in a banking context.  Therefore, the investor base can no longer applaud EPS growth driven by higher rates (flows through income statement) without accounting for the associated loss in AFS securities.

Higher rates driving down tangible equity

As of 4Q22, FFIN owns $5.47B securities paying 2.31% yield with modified duration of 6.33 years against $950mm of tangible equity. TBV/share was already down 35% (from $10.12 to $6.66) in 2022 due to higher rates. 

Bond math suggests a 100 bps increase in rates will cause a loss of roughly $346mm which is equal to 36.5% decline in TBV ($5.47B * 6.33% * 1 / 950). TBV likely to decline further in 2023 as the Fed continues to hike. 

The AFS portfolio is negative convexed

As of 4Q22, RMBS represents 51% of the AFS portfolio based on gross value.  RMBS has negative convexity which means duration rises as yield rises.

The toxic mix of higher yields and negative convexity manifested in 3Q22 when modified duration jumped to 6.44 years from 5.14 years in 2Q22 while RMBS gross value stayed constant. This means the aforementioned decline in tangible equity is understated as modified duration will further increase from 4Q22 level.

Net interest income benefit from higher rates is limited

According to management’s modeling, a 100 bps increase in rates will increase NII by $8.4mm while the impact to TBV will be negative $346mm.

Valuation

The stock currently trades at 4.5x P/TBV which is absurdly high given the current macro environment and AFS securities headwind.  4Q22 TBV/share is $6.66. 

I think 3x P/TBV is generous. For reference, BANF, a highly similar peer (mid-teens ROE, 15 year EPS CAGR of 10%, $11B earnings asset) with much less AFS losses baggage, trades at 2.6x P/TBV.

Bear Case

Interest rate stays at current level. No further losses from AFS.  FFIN earns $1.7 in 2023 and pays $0.68 dividend.  TBV/share = $6.66+1.7 - 0.68 = $7.7.  Target price = 3x TBV or  $23.1.

Base Case

Interest rate goes up another 25 bps and the Fed stops.  TBV/share takes a 9% hit and declines to $5.95. Target price = $18.

Risks

Fed funds futures point to possible cuts. If the Fed cuts rates aggressively, TBV will grow, the party continues and the stock could trade back to 25x P/E.

Catalyst

Higher interest rate; further deterioration of TBV