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Vol. V, No. 37

TOM BROWN’S BANKING WEEKLY: 9/11/20

Financial Services Insights and Intelligence

FIRST WORD: Exciting times at FIS. FIS is obviously huge, with 55,000 employees located in well over 100 countries. Its market capitalization is $91 billion, which puts it on par with Citi ($106 billion), and Wells Fargo ($99 billion). Not only is FIS one of the leading providers of core processing solutions for banks, it is also a leading merchant and capital markets solution provider. The company’s total revenues in the second quarter were right around $3 billion.  This week I was able to catch up with CEO Gary Norcross. I asked for the call to talk about a couple of big changes at the company, but we started with a more  general discussion.

Employees. FIS transitioned from 10% of its employees working from home to 95% within ten days, a challenge obviously made more difficult by the company’s global reach. Currently, employees who want to work from the office can do so, but no one will be required to until at least after the new year. Norcross mentioned day care availability, school openings, and rapid-transit conditions as all being important issues in management’s decision as to when to bring everyone back. He does not believe the company’s employees will ever travel as much for business in the future as they have in the past, since people can be so productive without traveling. He says productivity is higher than before WFH, but he attributes most of the increase to employees not taking vacation. FIS is constantly surveying its employees about how they feel about returning to an office environment; a few months ago, 85% of employees said they never wanted to return, but that has gradually declined to 65% now.

Worldpay. Last year the company expanded its merchant services with the acquisition of Worldpay. As of the end of the second quarter, the company had achieved $700 million in annualized cost saving and $115 million in annualized revenue synergies. So far, the acquisition is doing better than expected. The company has used its strong cash flow to pay down acquisition-related debt.

Banking solutions. Norcross said FIS set up 85 banking clients with a real-time PPP loan application processing system that could process two loans per minute, compared with the 45 minutes it took some to process one loan manually. My real interest in talking to Norcross was to find out more about the company’s development of its Modern Banking  Platform. When Norcross became CEO, he determined that the company needed to change how it was providing core processing solutions for banks. It needed to develop a new cloud-based core processing solution for clients that would enable them to reduce their tech costs and increase flexibility. Norcross says MBP will enable banks to reduce their legacy processing costs by around 25%. It wasn’t going to be good enough anymore to provide an updated software release once a year for its clients, or even once a quarter for its largest banks. Rather, the company needed to move to real-time changes. The company has now won its ninth MBP client, including four of the 30 largest banks. The first client is expected to move from beta testing to full deployment early next year. This could be a huge development for both FIS and the banking industry, so you can bet there will a lot of us watching closely.

 

HOPES TOO HIGH: I tend to not put a lot of stock in the purported market signals that emanate from the options market—they tend to be way too noisy, for one thing—but must admit that the difference lately between open call buys and open put buys seems to indicate that investors have become distressingly bullish:

NOT HOPEFUL: Or maybe not! The spread between self-described bulls and bears in the American Association of Individual Investors’ latest survey is still near record lows.

FEW WINNERS: Did you find that your own portfolio lagged while the market kept on going up, up, up? You’re not alone! Even as the S&P 500 was setting records last week, just 30% of its components had regained their old highs from January and February:

HOT ITEMS: Talk about a seller’s market. Real estate broker Redfin reports that the number of existing homes that are sold within two weeks of their listing is surging:

 

AGGRESSIVE: As far as that goes, home sellers seem to know they’re in the driver’s seat, and so apparently haven’t been shy about asking for a nice number when they put their house on the market. That’s one reason, I assume, that the gap between median list price and median sales price lately is huge.

RAIL RESURGENT: And here I was under the impression that this was going to be the worst recession since the Depression. Total U.S. railcar loadings are now close to where they were when the slowdown began, while intermodal traffic, which is more closely tied to consumer spending, is now running higher than where it was a year ago.

FEELING FINE: This is sort of surprising (to me, anyway). Even amidst an ongoing pandemic, and with so many people’s day-to-day working arrangements having been upended over the past few months, fully 65% of workers polled by Gallup say that they’re completely satisfied with the safety conditions of their workplace.

BACK TO THE OFFICE: Finally, a little common sense. In his interview with the Wall Street Journal on Monday, Netflix co-CEO Reed Hastings offers a view on working from home that seems to be increasingly at odds with what a lot of other CEOs have lately had to say on the matter:

I don’t see any positives. Not being able to get together in person, particularly internationally, is a pure negative. I’ve been super impressed at people’s sacrifices. [Emphasis added.]

Hastings is right, of course. There are all kinds of negatives to WFH, which is why, pre-pandemic, so many companies were out-and-out forbidding their employees from working remotely.

STAYING EMPTY: On the other hand! In New York City, at least, demand for commercial real estate is so dismal that CRE transactions fell by 32% in the first half, with total consideration falling by 54%. Prices of office buildings in particular fell by 28%.

A fair amount of that weakness is surely being driven by a growing consensus that a lot of New York office space isn’t going to be re-populated any time soon, right?

SLOW TO COME BACK: As if to reinforce the above, a survey of New York City employers by the Partnership for New York City found that just 8% of employees had returned to their office as of mid-August, down from a projection of 10% from a similar survey done in May. Only 26% of employees are expected to be back in the office by yearend.

FEELING GOOD: The banking industry seems to be doing a pretty darn good job at dealing with consumers during the pandemic. In a survey taken over the first two weeks of August, 48% of people polled by Gallup say they have a positive view of the industry, against just 22% who say they have a negative view.

NOSTALGIA, FOR THE WIN: This is a comeback I admit I didn’t see coming. In the first half of the year, sales of vinyl records topped sales of CDs for the first time in 34 years.

NOT SO BAD: The famous fact that September is the worst month of the year for the stock market—LPL Financial notes that since 1950, stocks have fallen by 1.1% on average in September, which makes it the only month when stocks have shown a meaningful decline—might not be as bleak as it seems. An average can be a hugely misleading statistic, after all. Writers at Fisher Investments point out, for instance, that going back to 1925, stocks have actually risen in September 55% of the time. During Septembers in presidential election years, they’ve been up 65% of the time.

STEADY ON: Here’s something the stock-market’s-in-a-bubble crowd might want to ponder: charted on a log scale and going back to 1871, the S&P 500 is almost exactly on its long-term trend.

AVE ATQUE VALE: Former Value Line research head Sam Eisenstadt, who in the 1960s invented the firm’s famous stock rating system that for decades consistently identified which stocks were set to outperform, died on September 5 at the age of 98. R.I.P.

OVERKILL: Might Congress perhaps be overdoing things with its ongoing recession-driven consumer liquidity-relief programs? I say yes! As DoubleLine’s Stephen Gundlach noted on Tuesday, even as the economy limps along and unemployment remains high on an historical basis, disposable income, including government transfer payments to individuals, is nonetheless soaring:

BAD IDEA: I can’t be the only one who thinks that the current profusion of actively managed ETFs is Wall Street’s latest effort to put one over on the investing public, can I? First, the whole notion of “active passive” management is a preposterous contradiction in terms. And an expensive one: from what I can tell, the typical active ETF charges an annual management fee of a whopping 50 basis points. Oh, and active ETFs are almost surely doomed to lag the market overall. What a con.

TOO MUCH: Speaking of ETFs, the late-July launch of a SPAC index by index manager IPOX—designed apparently so that a number of forthcoming SPAC ETFs will have something to track—might be a sign that the SPAC craze is at last a bit long in the tooth, no?

THIS ECONOMIC RECOVERY: The recovery may end up being more durable than is generally expected. Cornerstone Macro’s Nancy Lazar makes the point that the industries that are leading it, real estate and manufacturing, have among the highest job multipliers of any industry. Have a look:

LOOKING THROUGH THE CLIENT’S EYES: An age-old problem in banking is that, too often, employees get so caught up with the bank’s products, services, and nomenclature that they fail to truly understand what the customer’s real needs are. Speaking to the Financial Brand, Wells Fargo consumer head Mary Mack  addressed this very issue. “I like to tell our bankers that our customers are not interested in getting a mortgage. They’re really interested in buying a house,” she said. “They’re not interested in a savings account.  They’re interested in sending their kid to college. We have to start thinking in terms of the things that our customers really want to achieve and use what we do to help them accomplish their goals.” Amen.

CONSUMER CONFIDENCE AND JOBS: As is typical, this has not been an equal-opportunity recession.   Fully 39% of people from households making $40,000 or less have lost their jobs, compared to just 13% of those who were making $100,000 or more.

INSIDERS ARE SELLING: Corporate insiders sold $6.7 billion worth of stock last month, which strikes me as a lot. In fact, the August total is the highest level since November 2015, while the number of insiders selling was the most in two years.

BETTER TIMES: Might the pandemic be set to end sooner than a lot of people expect? Maybe! If I’m reading these charts from Johns Hopkins right, while new cases in Europe have spiked again, Covid-related deaths there have not. Here, for instance, is what’s been going on in France and Spain:

The apparent plummeting lethality of Covid is certainly a welcome development.

NO WAY: The consensus estimate for the loan-loss provisions at publicly traded banks with market caps over $150 million suggests a gradual decline over the next seven quarters. But one thing you can pretty much count on, given the adoption of CECL, is that, collectively, loan-loss provisions will not decline gradually. I expect the decline will look more like a stair-step down, with the biggest step down being in the first or second quarter of 2021.

MAIN STREET LOAN PROGRAM UPDATE: As bank CEOs have been telling me, the Main Street loan program is not effective. It has the capability to support $600 billion in loans to companies with fewer than 15,000 employees and revenues less than $5 billion. However, only $1.1 billion in loans have been made, with not a single loan in 25 states and not a single loan made by the big four: JPMorgan, Bank of America, Wells Fargo, and Citigroup. The program should be gracefully shut down.

EXCELLENT DISCLOSURE AND GREAT GRAPHICS: I still don’t believe investors understand what banks are doing with loan deferrals and the level of risk associated with the loans, but it seems like almost every day some bank improves its level of disclosure around this issue. OceanFirst Financial gave an investor presentation this week with charts showing what has happened with the deferrals it has granted to commercial and consumer borrowers, and what the bank expects of these loan totals going forward. Have a look:

 

RADIUS BANK UPDATE: You will remember Radius Bank is the traditional bank that CEO Mike Butler started transitioning to a national, digitally focused consumer bank. Earlier this year, Lending Club announced an agreement to acquire Radius for $185 million. Given that a nonbank is buying a bank, the regulatory approval process was, and is, expected to take a fairly long time, as Lending Club is forced to adopt burdensome bank practices. In the meantime, Radius continues to build out two key parts of its business. First is the national digital consumer bank utilizing partnerships with fintech companies such as Mantl, Alloy, and Treasury Prime. The second business is providing banking as a service for fintech partners such as what Cross River and The Bancorp do. This business received a big boost from the PPP loan program. The $1.5 billion-asset Radius originated about $700 million in PPP loans as a result of its partnerships. Butler really turned a lemon into lemonade!

 

FIRST FINANCIAL BANCORP: It’s hard for me to believe that it has been two and half years since the merger of equals between First Financial Bancorp and Mainsource Financial, a deal that put the combined company well north of the $10 billion threshold. This week I talked with CEO Archie Brown about the company’s business today. Some highlights of our talk:

MOE challenges.  Brown told a story about forming the new company’s management team that is typical of what I have heard in the past with other mergers of equals. He had to make some difficult senior management changes after about nine months of combined operations, but he is very happy now with the new team and how it is operating.

Cost savings. The company had projected a 35% reduction in expenses, but Brown says it turned out to be closer to 40%. The two companies’ branch network had significant overlap, so the combined company was able to eliminate 45 of its 200 branches. It has continued to rationalize its branch network, which today is just under 140.

Organic commercial loan growth.  Brown said the hardest part of the merger is generating commercial loan growth in the metropolitan markets outside of its headquarters city of Cincinnati.

Pushing hard to digital. At the time of the merger, the company had just eight people working to push the company to digital adoption. Today it has 50.

Covid response. All but five of the company’s branches are now fully open. The downtown office tower and two operations centers are operating at 25% capacity. As with most of my other discussions with CEOs lately, Brown doesn’t really care if those working from home go back to the office before the new year. He says the percentage that do will largely be determined by what happens with schools.

PPP loans. The company processed over 7,000 loans totaling $917 million, thanks to an internal automation effort and the nCino loan platform. First Financial hasn’t started yet, but is ready to help its borrowers negotiate the forgiveness process.

Deferrals.  The company was very active in offering its commercial borrowers loan payment deferrals, which it provided for $2.2 billion in balances, or 22% of loan balances. A little more than a quarter of the loans that received a 90-day deferral have requested a second deferral, including a high percentage of the company’s loan exposure to restaurants.

Pilot with Upstart. The company has teamed up with Upstart to offer unsecured consumer loans; it is too early to judge its success.

Acquisitions. Brown thinks that with the Fed’s plan to keep interest rates low for awhile will serve as a catalyst for many smaller banks to want to sell. He says he’s a ready buyer.

 

WEBSTER UPDATE: Last week I had chat with Webster Bank CEO John Ciulla. Some highlights:

Work environment. The company continues to operate with just 25% of its employees in a company facility. There is no pressure on employees to either come back or to stay home, but Ciulla says he has emphasized to his employees that they must continue to collaborate with others  and must continue to mentor even in this unusual WFH environment.

PPP. The company processed over 10,000 PPP loan applications and funded $1.4 billion in loans, using an internally developed processing system. Webster is prepared to start working the forgiveness process as soon as it feels the SBA rules are finalized.

Main Street loans.  Webster has made a few loans under this program, but it is largely a non-event for the company.

Loan deferrals and modifications. Webster is the only bank I know of that disclosed the amount of loans that received a payment deferral and the amount of loans where there was a covenant adjustment. At the peak, on May 8, Webster had $2.2 billion in loans which had received a payment deferral and $700 million in loans with a covenant modification. By June 30, the total payment deferrals were down to $1.4 billion and the modifications totaled $900 million. The loans with payment deferrals have continued to decline throughout the third quarter.

Loan demand is steady. Originations this year have been good, but there’s been almost no growth in non-PPP loans because of payoffs.

CECL. Ciulla is one of the few CEOs I have talked with who believes that using the company’s own historic loss rates by category is leading to excessive reserve building. With changes in underwriting practices and loan mix over the past few years, he says, the company’s credit risk has changed. I expect a significant reduction in the third quarter loan-loss provision from the second quarter level.

HSA bank. Webster is one of the three dominant players in the health savings account business, which has been largely unaffected by the pandemic. However, Ciulla did point out that investors find it less attractive today than they did in a rising-rate environment.  Even after the Fed raised the fed funds rate by 250 basis points a few years ago, Webster’s HSA deposit costs stayed largely flat at 20 basis points.

 

THE RISE OF VERITEX: I arranged a call with Malcolm Holland, the CEO of Veritex Community Bank this past week, for the simple reason that Veritex is an $8.5 billion banking company of which I knew nothing. Prior to his founding of Veritex ten years ago, Holland, then 49, was CEO of Colonial Bank’s operation in Texas. After the parent failed and was taken over by BB&T, Holland knew he didn’t want to work for BB&T, and decided instead to round up some investors and buy a bank. At the time, just about all the money being raised to buy banks was being spent on institutions with distressed assets, usually at deep discounts to book value, and with a loss-sharing agreement with the FDIC. But Holland didn’t want to mess around with that, and wanted to focus on growth instead, so he bought a $135 million bank in Texas at a then-outrageous 1.89 times book value. He said he calculated the difference between book value and what he paid was about $4 million, and that if he couldn’t make back multiples of that $4 million, then he wasn’t the banker he thought he was.

Holland then bought two more banks in 13 months, and spent the next three years consolidating everything, from management to systems. By the time he was ready to start acquiring other banks, in 2013, the banking world had recovered, valuations were significantly higher, and he was losing out to publicly traded banks, who were using their stock as acquisition currency. So despite being told that Veritex was too small to go public, that’s exactly what the company did, in 2014. In the last six years it has enjoyed strong internal growth and has kept making acquisitions, including one that had close to 50% more in assets than Veritex did at the time. Veritex now has $8.5 billion in assets, making it the ninth-largest bank headquartered in the state.

Holland’s business model is similar to Pinnacle’s and ServisFirst’s: be a business-focused community bank that maintains strong underwriting standards and low operating costs. Veritext’s net chargeoff ratio has averaged in the low-single-digits of basis points over the last five years, and its  efficiency ratio runs in the mid 40% range. The company processed over 2,100 PPP loan applications, funding over $400 million in loan balances, 15% of which were to new customers to the bank. When I asked Holland if he used an outside vendor to develop a portal for the loans, he laughed and told me the bank had been working for nine months to develop such a portal and couldn’t get it done, but when faced with the PPP program they had a portal open in just three days. (So many stories like this from bankers.)  When I asked about non-PPP loan demand, he told me the pipelines are filling and that he is very encouraged about loan growth prospects at the end of this year and into 2021.

The day we talked, Holland was headed into the office to meet with his top six managers for the first time in a while. The company has 57% of its employees working offsite, and a return-to-the-office plan will start to be worked on shortly. Holland himself was pleased to be reuniting with his team because he doesn’t believe “you can develop strategy using a video call.” I found Holland to be direct, confident, and humorous. He was against the CECL adoption but now that it’s been implemented and banks aren’t receiving any credit for reporting earnings, he has used it to the bank’s advantage by significantly building the loan loss reserve, and expects a lower provision in the second half of this year, and sharply lower next year when he thinks investors will care about earnings again. As for humor, when I asked him why the bank has no physical footprint in such a fast-growing market like Austin, he said the city’s growth comes from government, UT, and tech companies, and none of those areas can help Veritex. “Every time I buy a bank that has branches in Austin, I sell them. Great place to visit but not for banking.”

Veritex is another American business success story hiding in plain sight in the banking industry.

 

NEXT WEEK: A couple of housing related releases will bear watching. First, on Wednesday, we’ll get the National Association of Homebuilders’ Builder Confidence Survey for September. The consensus estimate is 78, unchanged from August. Then on Thursday, August Housing Starts will be released. The consensus looks for 1.46 million units, seasonally adjusted and annualized, vs 1.50 million in July.

THE LAST WORD: Everyone who was alive then remembers the vivid details of 19 years ago today. I was sitting on a delayed Delta flight to Atlanta to attend a Checkfree investor day when my Blackberry went off with news a plane had hit the World Trade Center. Twenty minutes later, the flight was cancelled and I headed to our office in the Met Life building in Manhattan. But another text told me the building was closing so I asked the cab driver to turn around and head to my home in Greenwich. My most vivid memory of the day was going over the Whitestone Bridge and seeing smoke billowing out of one of the towers as ambulance after ambulance went by me in the other direction. Living in Greenwich, and given that so many financial firms were located in the World Trade Center, I knew several people who died that day, but the one I think about the most on this day of remembrance is Tom Theurkauf who was a bank analyst at KBW.

I got to know Tom when he was the investor-relations contact at Shawmut Bank in Hartford. Shawmut at the time was a basket case drowning in bad commercial real estate loans. Its nonperforming assets were double digits as a percent of loans, a  level that no bank had ever survived. Tom was a great investor contact because he was informed, thoughtful, and just simply a nice guy. In March, 1991 I called him to check in on the company’s quarter, as I did with every company I followed at the time. It was bad, but I heard some encouraging signs about the second derivative of change. At the end of the call, I made some gratuitous comments about things getting better and then Tom, in his slow and deliberate way, said simply, “Tom, I think it would be worth your time to spend a day up here.” I had enough respect for him that we immediately made arrangements for me to spend a day with management in May. I was further encouraged by the meeting and, after talking to Tom in June, I became the first analyst to recommend the purchase of Shawmut. It was $3 per share at the time, and subsequently became a home run.

Tom Theurkauf was the polar opposite of the terrorists that flew the planes into the towers. He was smart, calm, funny, and a great family man. For the last 19 years, the image of the tower as I drove over the Whitestone Bridge, and Tom Theurkauf’s face, represent my anger over what happened that day, and are what I think most about. Tom was just 44. May this great man, and all the others who died that day, continue to rest in peace.

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Edited by Matt Stichnoth.

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