We’re back from a visit to Columbus, Georgia last week, where we spent time with the management of Synovus Financial (SNV). We are very bullish on Synovus, you may recall; the stock is one of the largest positions in the fund we manage. Our bottom line after our meetings: the Synovus story is still very much on track. Credit is improving on schedule, and the company is set to return to profitability in the first quarter of next year, and can generate “normalized” earnings within 18 months after that. If everything goes according to plan, we expect the stock to double over the next twelve months.
I’ve said in the past that I believe that in March of last year the bank stocks began what will turn out to be an extended, three-stage bull market. Phase 1 happened in 2009 as the stocks jumped on investor recognition of the fact that, no, the largest banks weren’t going to fail, after all, and would live to see another cycle.
We’re now in the early portion of Phase 2, which is being driven by a return to “normalized” levels of earnings and equity valuations. Earnings are depressed because credit expenses are still cyclically high following a nasty commercial real estate down cycle and the general economic recession. But credit costs have at last begun to head lower. If the leading indicators of such things are to be believed, the improvement will continue. The direction is no longer a topic for debate, just the pace of improvement.
Synovus is a publicly traded embodiment of what I expect to happen to bank stocks generally. In 2009, the company’s loan loss provision was 14 times higher than the level we believe is normal given its book of business (Chart 1).
As the loss provision ballooned, the company’s earnings of course collapsed. Synovus lost $4.07 per share in 2009 and has continued to lose money in 2010. But beginning in the third quarter of last year, the loan loss provision started to come down. By now, the company is solidly on the road to profitability in 2011. But, oddly, 18 of 22 estimates for Synovus for 2011 still have the company losing money for the full year.
Those analysts are kidding themselves. Just as the company’s loan loss provision didn’t rise in a linear fashion in 2008 and 2009, it won’t fall in a linear fashion as conditions improve. Chart 2 shows the high and low forecasts for Synovus’s loan loss provision, quarterly through 2011.
We believe the company will turn profitable in the first quarter next year, as its provision falls to $100 million and it has $25 million in OREO expense. As you can see, the debate is not direction. It’s about magnitude. With Synovus’s stock lately trading at just 0.8 times it tangible book value, (0.6 times when the company’s deferred tax asset is added back to book value), I find it hard to understand why only four of the 24 analysts who cover the stock have seen fit to rate it a “Buy.” We know the company will survive the crunch. We know it’s headed for a return to profitability. What more do these people want?
The Road to Normalized Provision and Earnings
Maybe what they want (at least, this is an objection to banks I’ve heard a lot lately) is more confidence that, since nonaccruals are still high and economic growth is slowing, the decline in provision really is sustainable.
But if investors are fixated on comparing a given bank’s nonaccruals to its loan loss provision, they’re watching the wrong thing—and (worse) they don’t understand what drives a loan loss provision in the first place. Contrary to what many investors believe, the level of a bank’s quarterly loan loss provision is not largely determined by the level or direction of its nonaccrual loans. Rather, the provision is determined by numbers that most banks don’t disclose: the ratings migration of its loan portfolio, along with the level of its chargeoffs.
What’s that? You don’t hear many bank analysts talk about ratings migration? As I say, that’s because most banks don’t disclose a whole lot about it. Still, migration is a key factor in driving loss provision. If you want to have confidence that a decline in a bank’s loan loss provision is sustainable, you need to figure out a way to get your arms around the issue. So allow me to offer a primer.
Let’s start with the basics. All banks grade their loan portfolios on some scale or another. Many banks, including Synovus, use a 9-point system where a “1” is a strong investment-grade credit (there aren’t too many of these left in the system at this point) and a “9” is a loss.
Banks then determine the size of their overall loss reserve by applying reserve factors to loans by category and grade. The factors are determined by recent loss experience. For example, “4”-rated commercial loans might require 200 basis points set up in reserve while, say, “6”-rated commercial loans might demand 800 basis points. Our estimate of Synovus’s loan portfolio by grade is on Table 1. This is only meant to be directionally correct, for illustrative purposes.
During recessions and real estate down cycles, not surprisingly, loans tend to downgraded more or less across the board. Result: loan loss reserve jumps. What’s more, the required reserve percentage increases exponentially as loans move into the worst loan grades.
But the downgrade process often moves in fits and starts. Usually at the beginning of a down cycle, for example, banks don’t downgrade loans fast enough. Then they’ll hurry and play catch-up (often “aided” by regulators) and often become too conservative just as the cycle is turning. Then the process reverses and loan upgrades begin outnumber downgrades.
We believe Synovus is well past that inflection point. Chart 3 shows the huge decline that has taken place in the company’s quarterly inflow of new nonaccrual loans.
We believe the company’s loan grading became excessively conservative in the first half of this year, as many loans were downgraded--but not to levels that required they be placed on nonaccrual. For evidence, the company’s “potential problem” loans (loans rated 5) have risen 38% this year while nonaccrual loans have fallen by 16%.
At our meetings in Columbus last week, we got the sense that the overall direction of new nonaccruals and total nonaccruals will continue be down (though not in a straight line) and that the downgrading of credits above the nonaccrual cutoff has largely been completed, and to an excessively conservative level.
If we are correct, these trends will require less in loan loss reserves and, increasingly, will reduce the need for the well-above-normal provisions.
As I mentioned, the other factor that has a big effect on provision levels is the level of net chargeoffs. Here, too, the numbers should continue to fall. Think of chargeoffs in three buckets: 1) chargeoffs that occur when loans become nonaccrual, 2) additional writedowns of existing nonaccrual loans, reflecting further declines in collateral value, and 3) all other chargeoffs such as consumer loans and small-dollar loans.
Of these three, the biggest contributor at Synovus lately has been chargeoffs from new nonaccrual loans. But this level has been declining as the inflow of new nonaccrual loans has fallen. That should continue. Plus, the average writedown of new nonaccrual loans should also fall (we estimate it has been running around 30% to 35% of the loan balance) since the loans that go on nonaccrual in upcoming quarters will tend to have stronger collateral support, and will be most likely to be rehabilitated, than earlier nonaccruals. (This tendency isn’t just true at Synovus, but at all banks that had significant residential construction loan problems.)
Next, the second-largest bucket of chargeoffs comes from additional writedowns of loans already on nonaccrual as a result of further declines in collateral value. We estimate that this has been running about $100 million per quarter, or around 6% of the beginning nonaccrual loan totals. We expect that number to shrink as nonaccruals decline generally, and also because of the extensive writedowns already taken on these credits, and because appraisal values have begun to stabilize.
So here is where we are. First, the downgrading of loans by grade has ended and should begin to reverse. Second, chargeoffs have begun to ease as new nonaccruals fall and asset values stabilize. That’s why the decline in Synovus’s loss provision will likely persist. It doesn’t have much to do with the overall level of nonaccruals as it does with the level of new nonaccruals and other downward loan migration. And as loss provision falls, profitability rises, and Synovus’s recovery inexorably continues.
We believe the path to Synovus’s recovery is clear, and the only debate is how fast the company will travel before it reaches its ultimate destination of normalized profitability. We estimate normalized E.P.S. of 40 cents per share and believe the company can be earning at that rate sometime in 2012. If so, then a year from now the company’s equity valuation will be based on that level.
Assuming Synovus trades at 12 times to 15 times earnings would imply a $4.80 to $6.00 stock price, or more than a double from common levels. In addition, the company is trading at 0.8 times its tangible book value and 0.6 times its tangible book adding back its deferred tax asset. Assuming additional near-term declines in book value and the deferred tax asset recaptured, the midpoint of our target price range would represent a valuation of only around 1.5 times tangible book value, a level well below the large-bank historical average and only in line with where the large-bank group trades today!
Synovus: Bank Stock on Steroids
Next week, Barclays will host a financial services conference, where most of the large banks will make presentations. We expect the tone to be very favorable, and be led by a discussion of improving credit quality trends. We expect Synovus’s presentation to be along those lines, as well. But the company’s earnings recovery figures to be more dramatic than that of most banks. This is a regional bank stock on steroids, as we begin another upward advance in the bank stock bull market.
What do you think? Let me know!