Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there’s still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).

Bank OZK Picks Up Steam! The Street Yawns (NASDAQ:OZK)

Last week, the bank reported third-quarter earnings: beating revenue and EPS Street estimates handily.

Revenue surprised to the upside by 3 percent. 3Q EPS came in at $0.84, trouncing $0.58 estimates. However, several other year-over-year metrics are what caught my attention.

In this article, we will offer an investment thesis and delve deeper into the fundamentals. In addition, we’ll add some color to the analysis by comparing Bank OZK results with two other well-managed regional banking institutions:

United Community Banks, Inc. (UCBI)

United conducts its operations through a community-focused operating model of separate community banks, which operates approximately 150 locations in Georgia, North Carolina, South Carolina and Tennessee. United specializes in personalized community banking services for individuals, small businesses and companies. Services include a full range of consumer and commercial banking products, including mortgage, advisory, and treasury management.

(Source: Reuters)

United Bankshares, Inc. (UBSI)

United Bank offers a range of commercial and retail banking services and products. It also owns nonbank subsidiaries which engage in other community banking services, such as asset management, real property title insurance, financial planning, mortgage banking, and brokerage services. Its loan portfolio comprises of commercial, real estate and consumer loans including credit card and home equity loans. The Bank operates across West Virginia, Virginia, Ohio, Pennsylvania, Maryland, North Carolina, South Carolina and Georgia.

(Source: Reuters)

I selected these peers by searching for banks of similar size, scope, and fundamental performance. Over the past year, OZK shares have held up better; however, all these stocks are down in 2020.

Here’s a quick-take summary on the three banks:

Bank OZK

United Comm. Bank

United Bankshares

Market Cap

$3.2 billion

$1.8 billion

$3.4 billion

P/E ratio (ttm)

11.8x

11.1x

11.5x

Dividend Yield

4.6%

3.4%

5.4%

52-Week Stock Performance

-16.8%

-30.4%

-34.3%

Bank OZK Investment Thesis

Bank OZK is one of the best-run regional banks in America. CEO George Gleason obtained control of the bank over 30 years ago; he’s grown a small, local bank into a regional powerhouse.

Bank OZK utilizes a unique business model. It relies heavily upon high-profile, complex commercial real estate transactions, strict underwriting standards, and high loan-to-deposit ratio. For decades, the model has resulted in superior returns, spreads, and credit metrics.

Currently, OZK shares are out-of-favor, along with most other banking stocks.

Nonetheless, Bank OZK just recorded a fine quarter whereby post-COVID green shoots emerged, and management appeared cautiously optimistic about the future. This catalyst may trigger the shares higher.

An 11.8x P/E suggests stock valuation remains compelling.

The dividend is secure, and the 4.6% dividend yield offers investors a solid income stream while waiting for the stock to reach its Fair Value.

Analysis Approach

We shall break down our analysis into several bite-size sections:

  • Asset Quality

  • Net Interest Income

  • Loan/Deposit growth

  • Capitalization, Returns, and Efficiency

  • Valuation

  • Risks to the investment thesis

Asset Quality

Especially during times of economic stress, asset quality becomes one of the most important bank metrics.

In 3Q 2020, Bank OZK recorded a 0.09% Net Charge Off ratio, and a 1.60% Allowance for Credit Losses/Total Loans ratio.

For years, the NCO% has been materially lower than FDIC peer averages. 2020 is no exception.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).Source: 3Q 2020 Bank OZK management comments

Throughout 2020, I’ve been following Allowance for Credit Losses figures closely. For the period ending September 30, 2020, ACLs as a function of total loans and leases drifted up to 1.60 percent. A year ago, ACL-to-loan was 0.61 percent. For perspective with two larger banks, the ACL-to-loan ratio was 2.07 and 2.20 percent, respectively, for Bank of America (BAC) and Wells Fargo (WFC).

As an adjunct, I’ve kept an eye on bank capitalization presuming all of the allowance for credit losses turn into write-offs. It the end of 3Q 2020, Bank OZK’s CET1 Equity/Risk-Weighted Assets ratio was 13.4 percent. In the event of a total ACL write-off, the CET1/RWA ratio falls to 12.0 percent; still comfortably above the required regulatory minimum.

The bank does have one significant, substandard accrual credit. It’s a front-and-center item when I review the quarterly reports. It’s covered in more detail in the “Risks” section of this article.

In addition, investors have expressed concern about the federal disaster relief loan repayment deferral program. At its peak, Bank OZK had $1.34 billion, or 6.9 percent of its loan book in deferral. However, by the end of 3Q 2020, the deferrals total $0.55 billion, or 2.8% of all loans.

During the 3Q earnings telecon, CEO George Gleason added the following remarks:

So, loans are coming off deferral and obviously the vast majority of those loans have just picked right back up and continued to pay and perform as we expected they would, and we would expect that the vast majority of the 2.8% remaining in deferral will continue to do so.

Here’s a quick 3Q 2020 asset quality comparison between Bank OZK and selected peers:

Bank OZK

United Comm. Bank

United Bankshares

Net Charge Off %

0.09

0.09

0.12

ACL / Total Loans %

1.60

1.14

1.35

Fed. Loan Deferral Prog. % 09/30/20

2.8

3.1

~5

Bank OZK compares favorably with these two banks.

Net Interest Income

Broadly speaking, banks generate cash on the spread between what they make on loans versus what they have to pay depositors. Net interest income is a measure of what gets to the bottom line. It’s a bank’s bread-and-butter.

After bottoming in 1Q 2020, Bank OZK increased NII in both the second and third quarters. This was a pleasant surprise.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).

Source: Company Press Release

Part of the surprise was due to the fact the Net Interest Margins continued to shrink. Nonetheless, we also see Bank OZK reports NIMs substantially better than FDIC peers.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).Source: Company Press Release

Nonetheless, not only did Net Interest Income grow, but management expressed cautious optimism they can continue to stabilize or improve it. They believe this will be accomplished by reducing COIBD (Cost of Interest Bearing Deposits), and opportunistic deployment of excess cash. Here’s what management had to say in the 3Q 2020 earnings remarks:

The Fed’s substantial and rapid cuts in the Fed funds target rate in the first quarter of 2020 caused our loan yields to drop much more rapidly than we have been able to adjust our deposit rates. We expect it will take us several more quarters to adjust our deposit rates downward to more closely align with the reduction in loan yields. In addition, during the quarter just ended and throughout 2020, we have held increasing amounts of liquidity in the form of cash balances and very short-term securities, and this additional liquidity has had a negative impact on our net interest margin.

The Bank OZK scorecard versus the peer group follows:

Bank OZK

United Comm. Bank

United Bankshares

NII growth %

2.3

30*

7.6

Net Interest Margin %

3.69

3.27

3.18

*includes NII growth resulting from acquisition activity. Organic NII not available.

OZK grew Net Investment Income modestly. Please note the figures for UCBI and UBSI reflect increases due to acquisitive activity. Core figures were not available. Over the past year, Bank OZK has made no acquisitions. Therefore, the comparison isn’t apples-for-apples.

Loan and Deposit Growth

Banks thrive on loan and deposit growth. Loans are the lifeblood of a healthy bank, and deposits are foundational.

In 3Q, Bank OZK continued to grow its loan/lease portfolio and deposits. The total loan book grew 9.2 percent, while deposits improved by 15.4 percent. Year-over-year non-purchased loans grew 12.9 percent. This organic loan growth rate was superior to many other banking institutions.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).

Source: Company Press Release

Several years ago, Bank OZK acquired several smaller banks. The purchased loans are now rolling off, thereby becoming a smaller and smaller part of the total loan book. Non-purchased loans are also being paid off; however, COVID temporarily slowed the breakneck pace experienced in 2019. It’s expected to pick up again in 2021. More on this in the “Risks” section of the article.

The deposit growth results have quieted the skeptics. Some analysts believed OZK chased too much “hot money,” suggesting when rates dropped the bank would lose a chunk of its deposit base. Not true. Bank OZK has a well-refined deposit management scheme. It’s been put to the test, and stands tall.

Meanwhile, the bank’s loan-to-deposit ratio is 91 percent. Traditional banks do not maintain this high a ratio. For Bank OZK management, the figure is part of the business plan: contributing to higher margins and net investment income. As a matter of fact, over the past seven years, the 91 percent marker is towards the bottom of desired spread.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).

Source: Company Press Release

On balance, these loan and deposit figures are quite good. Stepping back from the numbers, management is seeking to grow the loan book, particularly via the RESG (Real Estate Specialty Group), which handles the CRE business. These are the largest, most complex lending projects. The resultant growth treadmill is challenging. As existing loans are paid off quickly, it requires the RESG to replace these: without compromising credit quality. This is a risk to the investment thesis acknowledged in the “Risks” header of the article.

In recent years, Bank OZK sought to diversify its loan/lease book by entering the marine and RV lending markets. This provided solid growth and non-CRE diversification. However, management is now finding these markets saturated, and has decided to back off. Despite a COVID-induced boom toward RVs, Bank OZK believes lending field is crowded with too many players doing lower-margin, higher-risk deals. Management refuses to participate. Steadfastly, they won’t chase deals for growth’s sake alone.

Another quick recap versus the peer group:

Bank OZK

United Comm. Bank

United Bankshares

Loan Growth %

9.2

3.1*

~2.0

Deposit Growth %

15.4

8.0*

~2.0

Loan-to-Deposit ratio %

91

80

90

Source: company 3Q 2020 earnings reports and presentation materials

* “Core” growth ex merger and acquisition activity. Estimated for United Bankshares.

Clearly, Bank OZK demonstrates better loan and deposit growth versus the selected peers.

Capitalization, Returns, and Efficiency

Bank capitalization offers investment insight as to how well an institution can weather a financial storm. Bank regulators set minimum requirements for several key capital ratios.

I like to key on CE/A or Common Equity over Assets ratio. The typical permutation of this metric is CET1/RWA or Common Equity Tier 1 divided by Risk-Weighted Assets. For smaller banks, it’s generally okay to concentrate upon the former.

As of 9/30/20, Bank OZK maintained a robust 15.6% common equity to total assets ratio. The bank may be considered well-capitalized. As pointed out earlier in this article, the strong capital buffer offers insulation even in the event all the current allowance for credit losses become actuals. The regulatory minimum for smaller banks is ~8 percent.

Despite the high capitalization ratio, OZK maintains return-on-equity and return-on-assets materially above industry averages. This is a function of several factors, including superior NIMs and a lower efficiency ratio. Indeed, Bank OZK records one of the best efficiency ratios in the business.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).

Source: Company Press Release

The following chart highlights the CE/A ratio, return info, and Efficiency Ratio for Bank OZK and selected peers.

Bank OZK

United Comm. Bank

United Bankshares

CE / Assets %

15.6

11.5

16.5

RoA %

1.63

1.09

1.56

RoE %

10.5

10.1

9.7

Efficiency Ratio %

41.8

54.1

53.4

Bank OZK heads the group in all categories.

Valuation

If one believes the fundamentals are sound, the investment decision pivots to whether the stock is cheap.

By most historical measures, OZK stock is quite cheap.

On a price-and-earnings basis, a F.A.S.T. Graph illustrates the current situation:

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).Source: fastgraphs.com

When interpreting the chart, the big question is whether to accept the long-term 15.9x P/E ratio. For most bank stocks, this ratio is high. Historically, Bank OZK investors awarded the stock a higher multiple given the business’ ability to grow faster than most banks. Post-Great Recession, OZK grew EPS at nearly a 14% clip per year. However, in 2018 and 2019, earnings growth slowed significantly. 2020 is a bust.

So what’s ahead?

Well, current estimates indicate 2021 will be a rebound year (pending C19 abatement), and 2022 suggests a more normalized run-rate. Previously, Bank OZK generated much of its growth via acquisitions; this isn’t a go-forward assumption I’d make.

So let’s presume Bank OZK can continue to grow earnings through its business model, but the growth rate will ease from mid-teens to high-single digits. Using this premise, a more conservative forward P/E is in order. Using the Modified Graham Formula (I’ve outlined this in other articles), I suggest a 13x multiple is appropriate.

Here’s the same F.A.S.T. Graph, but I’ve added a pink line representing a 13x multiple.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).Looking towards a 2021 earnings rebound, a $36 to $37 price is reasonable. See the box on the right-hand side of the chart.

Next let’s think about price and book value per share.

Bank OZK management has grown BV consistently over a long period of time.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).

Source: Company Press Release

The following F.U.N. Graph plots the 2009 to 2019 Bank OZK price-to-book ratios.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).The current P/B is 0.75x.

Unquestionably, the P/B ratio is at a low ebb. But should it be less than 1x? I think not.

Given ultra-low rates, but strong return-on-equity, I can defend a 1.2x P/B value. (There’s some arithmetic behind this. It involves interest rates, beta, and book value. I’ve outlined it in previous posts).

Bottom line: Given Bank OZK current $32.37 BV, a 1.2x P/B ratio suggests a $38 to $39 share price is reasonable.

Combining these valuation methodologies, my Fair Value Estimate is $36 to $39, or ~$37.50 at midpoint.

Bank OZK stock trades at about $24.40 today. That indicates strong upside potential.

To round out the exercise, let’s check out F.A.S.T. Graphs for UCBI and UBSI.

First up is United Community Banks:

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).For United Community Banks, the chart indicates earnings inconsistency and lower forward EPS growth rates than Bank OZK. There appears to be value in the stock, worthy of additional due diligence, but it’s hard to award a 13x multiple on a bank stock with low-to-mid single-digit future earnings. Furthermore, UCBI owns a 1.0x P/B ratio, so the P/B valuation on face is already higher than OZK. United may be a very good stock, but Bank OZK appears to combine better forward growth with deeper value.

Moving onto United Bankshares:

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).Here we have a different situation.

Long-term earnings growth is considerably lower than Bank OZK, but it’s consistent. Indeed, the price-and-earnings relationship indicates significant undervaluation. In addition, throughout the period we find a strong and growing dividend; the current yield is over 5 percent. On the other hand, even if we accept a 16x multiple, the shares aren’t as undervalued as Bank OZK: United Bankshares now trades ~$26 with a $34 valuation on a 16x P/E. That multiple just seems too high. It’s not obvious why one should award United three additional P/E turns versus Bank OZK.

United Bankshares’ P/B is 0.75x. That’s comparable with Bank OZK’s. We’ve got a push there.

On balance, I believe UBSI is worth additional due diligence; however, Bank OZK appears to have somewhat better fundamentals, and at least equal, if not better, stock value.

Bank OZK Risks

On the fundamentals and valuation, the initial Bank OZK investment thesis appears supported by the data.

The two selected peers offer good investment attributes as well, deserving additional investigation. However, neither bank nor stock undercuts the validity of the Bank OZK thesis.

But what about what can go wrong? Good investors are mindful of not just fundamentals and valuation, but risks and catalysts.

For Bank OZK, there are three significant risks to the thesis. The first is a macro risk. The others are more granular micro risks:

  • A renewed economic slowdown, induced by government shutdowns/fears over COVID

  • The heavy CRE composition of the Bank OZK loan book; specifically one significant, substandard loan

  • The 2021 treadmill

COVID-related Economic Risk

This risk (economic uncertainty or an actual contraction due to government-mandated shutdowns) is self-explanatory. I’ll not elaborate here.

Lake Tahoe Townhouse Project: A Substandard Loan

The second risk requires additional background.

For several quarters, Bank OZK has been reporting a substandard loan in the Lake Tahoe region of California. The $57.5 million loan, funded during the Great Recession, is struggling. Bank management has taken a $14 million ACL on it. The current loan-to-value is about 95 percent. In recent quarters, the prospects for the project have improved, and the LTV has fallen below 100 percent.

Bank OZK publishes a quarterly “bubble chart,” and this loan is always front-and-center during the conference call:

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).

Source: Company Press Release

Note there is some management commentary below the chart about this loan.

It should be noted in RESG’s 17+ year history, only a small number of credits have incurred losses, resulting in a weighted average annual net charge-off ratio (including OREO write-downs) for the RESG portfolio of 12 bps.

Generally, most investors will tell you now is a lousy time to buy banking stocks. However, for the patient and intrepid, there's still a couple of names to consider. One of these is an old favorite of mine, Bank OZK (OZK).

Source: Company Press Release

Nonetheless, investors should be mindful of this loan. In 2018, a similar bad loan (one of only five in the last 17 years) ended up going south. The stock price tanked.

It will take another year or two before this more recent loan may work its way clear.

The 2021 Treadmill

Here we have management execution risk.

The Bank OZK business model generates above-average returns/growth through focused underwriting and a high level of capital deployment. When loan pre-payment velocity increases, it pressures the RESG team to redeploy the capital quickly and efficiently. Otherwise, the loan-to-deposit ratio falls, and other growth metrics along with it.

Between 2015 and 2017, the bank acquired several smaller banks. Purchased loans associated with these banks are rolling off the book. In addition, low interest rates are encouraging accelerated loan pre-payments via the non-purchased loan book. Bank OZK is facing a stretch of unusually high pre-payment velocity. The pace picked up in 2019, but has taken a breather in much of 2020, largely due to the pandemic. However, the underlying drivers behind these pre-payments haven’t changed. Therefore, presuming CRE activity continues to rebound towards a more normalized rhythm, management has warned that pre-payments are likely to re-accelerate sharply in 2021.

So long as the RESG team can keep the treadmill running, this development isn’t a problem. On the other hand, if the team 1) fails to find enough new business to backfill these pre-paid loans, or 2) makes the mistake of softening credit standards to keep the treadmill running, there is risk to the underlying business model.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2020 investments.

Disclosure: I am/we are long OZK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.