|Shares Out. (in M):||165||P/E||18.5||16.2|
|Market Cap (in $M):||14,400||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
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First Republic is a simple story. The bank targets high net worth customers in the most structurally attractive markets and grows with them over time. At the heart of the business is a deep-seated client-focused service culture that has manifested itself in the form of one of the highest net promoter score rankings in the country, industry-leading customer retention rates, and strong loan growth supported primarily by existing customers and direct referrals. Through its entire history, the company has stuck to its knitting. Its loan mix has remained consistent in terms of geographic and product mix, and loan underwriting standards have always been extremely conservative, which has resulted in industry-leading loss rates through multiple cycles and strong, consistent profitability.
When the company was founded in 1985, its goal was to attract the next generation of high net worth households by delivering exceptional service, and the primary starting point for a new relationship was the origination of an attractively priced jumbo mortgage for the purchase of a first home. As such, the typical age for a new customer has historically been in their 30s, and FRC’s goal from that point on was to retain these attractive customers and grow with them over time. Having successfully applied this strategy for 30+ years now, the median age of its largest clients is 58, presenting the company with a natural tailwind to grow its wealth management business, but also a challenge in terms of its ability to re-stock with the next generation of wealth. Enter the millennial strategy.
In FRC’s core markets, high home prices, increased student loan debt burdens, and generational changes in the perception of home ownership have increased the average age of a first-time homebuyer by almost 10 years to over 40, significantly reducing the lifetime profit potential of the average customer. In response, FRC has introduced student loan refinance and partner loan programs as the new ‘hooks’ to gain access to the next generation of wealth earlier. By targeting the highest quality borrowers and offering attractive refinance terms with discounts for early pay, FRC is able to gain access the most attractive customer group 10+ years earlier, setting up an attractively long runway for future loan and deposit growth.
The architect of FRC’s historical and current strategy is CEO Mr. Jim Herbert. Mr. Herbert founded the company in 1985, took the company public in 1986, oversaw its sale to Merrill Lynch for $1.7bn in 2007 (3.6x TBV), and lead a management buyout from Bank of America in 2010 for $1bn (vs. a current market cap of ~$15bn). In his 32 years at the helm, FRC has increased its enterprise value at a 24% CAGR, while its stock price has increased at a 19% CAGR since rejoining the public markets in late 2010 (vs. +13% S&P). Mr. Herbert, 73, was originally set to retire at the end of 2017, but in agreed to stay on as CEO through 2020 and remain as Executive Chairman through 2025. Beyond Mr. Herbert, the company has a deep bench, and executive leadership could be set for many years as it appears the heir apparent is President Ms. Gaye Erkan, who is just 37 years old.
Since the 2016 election, FRC has seen its price-to-tangible book decline from ~2.2x pre-election to ~2x current whereas regional banks have seen their multiples expand 12% and money center bank valuations have expanded by ~1/3. As a result, FRC has seen its valuation premium compressed to 7% vs. regional banks (vs. 14% on average for the past five years and 16% vs. money center banks (vs. 41% on average pre-election), which strikes us as overly punitive.
To be clear, FRC’s premium should have compressed relative to peers, we just think the compression is overdone. It was not a beneficiary of tax reform relative to other banks, and the changes related to SALT & deductibility of mortgage interest have the most impact in its core markets. Moreover, management has ratcheted up its expense investment and issued shares to support its future growth over the past few years, which while consistent with its historical focus on the long-term, diluted the per share operating leverage despite the bank’s strong growth. In past few quarters, however, the expense ratio has started to level out, and after a recent equity raise, the bank appears sufficiently capitalized to provide loans in any environment, so we would expect better per share operating leverage going forward. Given our expectations for mid-teens loan growth and a growing stream of non-interest income, we expect the company to generate double-digit earnings growth over the medium-term, supporting an attractive total return.
First Republic is a California-chartered commercial bank and trust company headquartered in San Francisco specializing in providing personalized, relationship-based services, including private banking, private business banking, real estate lending, and various wealth management services. Roughly 83% of revenues are derived from interest income (primarily through loans but also from the ownership of other interest earning assets), and the remaining 17% of revenues is generated through non-interest income, primarily wealth management fees (~63% of non-interest income). As of June 30th, the company had total assets of $96bn, total deposits of $75bn, total equity of $9bn, and total wealth management assets of $131bn.
The bulk of its loan book is single-family loans and HELOC (55% of outstanding loans), but the company also provides loans for commercial real estate and multi-family (combined 23% of loans), and engages in business lending (14%), as well as a host of other loan activities (remaining 8%) including SF and MF construction loans, stock secured loans, partner loans, and student loan refinancing loans. Its business loan portfolio is concentrated in non-profit organizations/schools (36% of business lending) and PE/VC capital call bridge loans (36%), with the remainder spread between a variety of targeted verticals. The company maintains conservative underwriting standards across its entire book of business, with LTVs on average below 60% at the time of origination.
The company operates through 75 office locations primarily in San Francisco, Palo Alto, Los Angeles, Santa Barbara, Newport Beach, San Diego, Portland (OR), Boston, New York City, Greenwich, and Palm Beach – areas which are among the largest, fastest growing, and highest density in terms of high net worth households across the U.S. Almost 2/3 of outstanding loans are located in California, with the NYC metro area (22%) and Boston (8%) the other large regions.
Simple business model focusing on banking services for the wealthy. First Republic is different from typical banks in that it (1) primarily focuses on high net worth households (~50% of deposit accounts), which is defined as a household with over $1mn in investable assets and (2) limits its geographic presence to the most vibrant markets in the US. The company is a plain, vanilla bank – it does not engage in activities common for large banks such as investment banking and capital markets trading, and the majority of its revenue comes from traditional lending and wealth management services. Its core competency is delivering exceptional, relationship-based service with a strong focus on the customer. This is not a business that ‘nickels and dimes’ customer as management believes the short-term impact of foregoing fee income is more than made up by the goodwill engendered with a customer base that will only become more valuable over time. Instead, the company focuses its entire effort on providing a great customer experience, which helps with both retention and new client growth.
Thus far, management’s strategy has resonated well with customers as evidenced by an industry leading net promoter score, well below average customer attrition, and strong growth from existing clients and direct referrals (>70% of new deposits and loans), which has supported strong loan and deposit growth at the firm (+19% and +20% CAGR, respectively, since 2007).
Relationship manager quarterbacks the customer experience. At the center of First Republic’s business model is the relationship manager, i.e. the quarterback of the customer relationship. The relationship manager’s (RM) job is simply to deliver the services of the bank to the customer, acting as the customer’s advocate across the entire bank. From the initial point of acquisition – typically the origination of a jumbo loan for the purchase of a single-family home - the RM serves as the customer’s initial point of contact within the firm and generally remains their primary point of contact for the life of the relationship. In the customer’s eyes, the RM IS their bank. Even if they are promoted, the RM continues to manage existing clients because management does not want the customer to feel like they are being demoted to a new contact point just because their relationship manager gets more responsibility.
Secret to success is an entrepreneurial culture that is supported by a compensation structure that aligns everyone’s incentives appropriately. First Republic has an entrepreneurial culture in which the RMs truly ‘own’ the customer relationship and are compensated accordingly. Unlike most banks, RMs are compensated based on each customer’s entire relationship with the bank and more than half of the typical compensation to an RM comes from selling products other than loans. This makes it extremely challenging for a banker to leave the company and make as much money at another shop, which has contributed to employee stability – a key ingredient in a client-focused firm. In fact, since inception, 90% of loans have been originated by bankers that are still with First Republic.
First Republic also employs a ‘carrot’ and ‘stick’ strategy relative to RM compensation. RMs are compensated based on the products sold to clients, but in all instances, a material percentage of the compensation comes in the form of a multi-year deferred compensation trailer. Another interesting aspect of FRC’s compensation is the clawback provision where the RM is responsible for the loan performance throughout the life of the loan. If the loan goes bad, the banker needs to work it out, and if a loan cannot be worked out, the RM is on the hook for up to 3-4x the money he or she made originating the loan. This two-fold strategy directly incents RMs to provide suitable products for the customers (so they remain happy customers) that are also appropriately conservative to ensure losses are minimized.
Incentive structure supports conservative underwriting practices. With the clawback in place, lenders feel as if they are lending their own money, which results in a much more conservative credit culture than the typical business. The bank only offers a limited number of loan products and generally operates in a limited number of industries. Loan underwriting standards are extremely high, with average loan-to-values in the 50-60% range for residential loans while multi-family, CRE, and construction LTVs are closer to the 50% range, and these have remained consistent over time. The bank will aggressively price loans, but it will not be flexible on its credit standards.
Thus far, the strategy has been extremely successful. In its 32 years in existence, FRC has funded over $180bn of loans while cumulative charge-offs are only $325mn, which is equal to less than 1bps per year. For its single-family residential loans, cumulative net losses total just 7bps. And during the Dotcom implosion, FRC reported zero losses in San Francisco/Silicon Valley despite the NASDAQ declining 67% from 2000 – 2002.
Service culture and incentive structure creates a virtuous cycle supporting strong loan growth, negligible loan losses, and consistent profitability. In our view, the two drivers of FRC’s strong historical loan growth are (1) its service culture and (2) low loss rates, and in many ways its low loss rates actually make it easier to provide better service. Low loss rates enable the company to aggressively price loan products while still maintaining consistent profitability, so both the customer is happy and the bank is still able to earn a satisfactory return on investment. Since inception, FRC has never had an unprofitable year, and its net interest margin has been exceptionally stable despite significant volatility in the Fed Funds rate. Since 2002, FRC’s net interest margin has remained in a tight range of ~3.0% - 3.6%.
FRC has several opportunities to continue its strong growth. We see several attractive opportunities for First Republic to continue to grow its business, including:
Continue doing what it is doing. Despite strong growth in its core markets, FRC has just a 4% market share of high net worth households in its markets (up ~100bps since 2003), so there is an opportunity to grow by increasing market share within its existing markets. FRC should also benefit just by holding market share in these markets, as HNW household population growth in its core markets continues to outpace most markets in the world.
On a recent call, management noted that the uptick in rates had caused competitors to pullback their resources in mortgage lending whereas FRC is doing the opposite. Arguably, FRC should pickup market share even faster in less attractive environments as capital is withdrawn by its peers, suggesting the company can continue to grow at attractive levels even in choppier markets.
Expand into new markets. While the markets FRC operates in are first class, there are several other extremely attractive markets it could enter into should it desire to do so.
Continue to grow its wealth management business. When FRC first opened its doors in 1985, its goal was to target the next generation of high net worth households through the origination of a jumbo mortgage for the purchase of the customer’s first home. As such, the bank’s customer base skewed towards the younger side at the time. Having now successfully applied its strategy for 30+ years, the banks most valuable customers are now in their 50s/60s, presenting a natural tailwind for FRC’s private wealth management business. Through a combination of organic growth, acquisitions (Luminous Capital in 2012 and Constellation Wealth Advisors in 2015), and lift-outs (most notably from Credit Suisse as they left the US Private Wealth market in 2015), FRC has increased assets under management or administration to $131bn (+28% CAGR since 2011) and fee income to $356mn (+32% CAGR), resulting in >700bps increase in fee income as a percentage of revenues. We expect this business to continue to attract assets at a rapid clip, resulting in further increases in fee income and higher returns on equity.
Capture the new generation of wealth via professional loan programs and student loan refinancing. While the high median age of its largest clients represents a tailwind for the Private Wealth Management, it does present a challenge in terms of the company needing to re-stock its client base to capture the next generation of wealth. In First Republic’s core markets, high home prices and soaring student loan debt have increased the median age of first-time homebuyers (FRC’s historical point of customer acquisition) from the low 30s to over 40. To capture customers earlier, FRC has introduced partner loan and student loan refinance programs as the new customer acquisition tools. The partner loan program is a program designed for young professionals in professional services firms that have been given the opportunity to buy into a firm or a fund but lack the capital, while the student loan program (Eagle Gold All-in-One) offers high performers the opportunity to refinance burdensome student loan debt at attractive rates. Combined, these two programs represent just 4% of total loans but ~28% of households (up from 20% a year earlier).
The true potential growth engine looking forward is the Eagle Gold All-in-One plan as it gives FRC (1) a viable product in what is a $1.4 trillion marketplace and a (2) valuable customer acquisition tool for today’s millennial who may have different views on the value of home ownership vs. prior generations. Based on our due diligence, FRC is offering rates that are well below government loans and competitive with private lenders such as SOFI. Moreover, the bank has no prepayment fees and is providing borrowers with an additional 2% interest rate rebate if the customer pays off its loans within 48 months because in the banks eyes, the customer’s lifetime profitability is only enhanced the faster these loans are paid off.
Like the rest of its portfolio, losses on these programs are tiny, with just 2 accounts >30 days delinquent and 3 charge-offs in the All-In-One plan and only 1 delinquency and 0 charge-offs in the professional loan program. Management is not anticipating material losses despite the perceived riskiness of student loan lending because the work done to assess the borrower’s credit-worthiness, the risk controls in place to ensure the RM’s incentives are aligned, and the targeting of HENRYs (high earners not yet wealthy) is consistent with all of its other products. While the dollar impact of these programs is likely to be modest in the near-term, the potential to capture incremental share of high net worth households even earlier than it otherwise would sets the bank up to comfortably grow with these households over time.
Strong and stable balance sheet and low cost deposit base enables the business to benefit from rising rates. As expected of a bank with FRC’s culture of conservatism, the company maintains an exceptionally strong balance sheet, with leverage and risk-based capital ratios well above regulatory requirements and expected to remain well-above average for the foreseeable future. Management aims to have 18-24 months of growth capital on hand at all times to ensure the company is able to provide lending services to its clients in all markets, and the company will opportunistically access the capital markets equity, preferred stock, and or debt to ensure it can meet funding needs.
First Republic also has a reasonably asset sensitive balance sheet, with roughly 40% of its residential loans repricing/maturing within a year, and loans growing in the mid-to-high teens. Roughly 85% of liabilities are deposits, with debt funding less than 15% of total liabilities (less than 1% short-term debt), and its mix of deposits skews to low cost business deposits and wealth management cash sweep deposits. There has been concern about its savvier customer base demanding higher rates, but the company’s deposit beta has only been ~20%. This will likely trend higher, though the company maintains that it has a lot of levers in a rising rate environment to continue to grow net interest income.
Leadership firmly in place through the middle of the next decade. The architect of FRC’s historical and current strategy is CEO Mr. Jim Herbert. Mr. Herbert founded the company in 1985, took the company public in 1986, oversaw its sale to Merrill Lynch for $1.7bn in 2007 (3.6x TBV), and lead a management buyout from Bank of America in 2010 for $1bn (vs. a current market cap of ~$15bn). In his 31 years at the helm, FRC has increased its enterprise value at a 24% CAGR, while its stock price has increased at a 24% CAGR since rejoining the public markets in late 2010 (+1,050bps vs. S&P). Mr. Herbert, 72, was originally set to retire at the end of 2017, but in May agreed to stay on as CEO through 2020 and remain as Executive Chairman through 2025. Beyond Mr. Herbert, the company has a deep bench, and executive leadership could be set for many years as it appears the heir apparent is President Ms. Gaye Erkan, who is just 37 years old.
Summing it all up - It is really hard to duplicate this model. First Republic enjoys several points of differentiation from peers that make its business model extremely hard to replicate, in our view: (1) The company focuses exclusively on core markets (SF, SoCal, NYC, BOS, Palm Beach, and Portland OR) that contain a disproportionate percentage of high net worth households and targets these high performers who tend to increase their net worth at a faster rate than other households, enabling the bank to outgrow the market just by retention; (2) FRC benefits from a large asset base but a small customer base, which enables the bank to provide a high level of customer service while being able to offer more services than a boutique bank; (3) The bank has an entrepreneurial culture where the relationship manager (RM) 'owns' the customer relationship and is compensated based on his/her ability to build deep, stable long-term relationships in all areas of the bank. The nature of RM compensation encourages conservative lending practices and collaboration between different business lines, which helps maximize FRC’s share of wallet over time and results in extremely low loss rates on loans; (4) Low loss rates enable the company to aggressively price products to get customers to 'trial' services without sacrificing core profitability: and (5) Its consistent profitability and focus on maintaining a strong capital base at all times allows the company to be ‘there’ for its clients in all markets, which has translated into share gains in prior downturns when traditional banks reign in lending (and savvy HNW customers tend to capitalize). While there are a lot of banks out there that benefit from a portion of these factors, First Republic is the only one that benefits from all of these factors, making it extremely challenging for a competitor to replicate its business model, in our view.
Risk Factors: Key risks relate to (1) macro factors, (2) increased competition for HNW customers, (3) an inability for the business to scale its service model as the number of clients increases, and (4) potential challenges marrying the banking and PWM businesses, particularly with recent acquisitions.
•If the economy were to falter, FRC and all other banks would experience multiple compression. From a business perspective, we would expect FRC to gain share given its exposure to HNW households that typically can capitalize on difficult economic conditions.
•To the extent competition for HNW customers heats up, client growth and profitability could be negatively impacted, though we believe FRC’s model is sufficiently differentiated such that competition would have a difficult time replicating its business and taking share.
•FRC has an extremely high asset-to-customer ratio that enables the bank to provide a high level of service to its customers that is difficult for larger banks to compete against. To the extent growth in categories such as student loans increases the number of clients faster than the company can scale its customer service capabilities, the perception of FRC could be negatively impacted.
•Outside of its acquisitions in Private Wealth Management and its recent purchase of Gradify to enhance its student loan offering, FRC’s growth has been entirely organic. Thus far, it appears that the PWM integrations have proceeded according to plan, though we are always on the lookout for integration risk.
Continued strong performance.
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