FRC: A rare bank compounder
First Republic represents a fascinating and unique case study as a rare compounder in the U.S. banking sector. FRC was founded in 1985 by Jim Herbert to provide residential mortgages to San Francisco area professionals. Since its founding FRC has compounded its capital by an incredible 26%/yr., making FRC the 14th largest bank in the U.S. by market cap. Along the way, FRC IPO’d in 1986, was purchased by Merrill Lynch in 2007, and then management led a buyout in 2010, before FRC initiated a second IPO later in 2010.
FRC initially focused on residential mortgages and has added other product lines over time including multifamily (1990), Commercial Real Estate (1989), Business loans (2000), and Wealth Management. FRC explicitly avoids business activities such as proprietary trading, equity and debt underwriting and market making, sub-prime lending, and exotic derivatives, etc. and has avoided the major controversies and regulatory fines that have plagued larger banks.
Compared to similarly sized banks by assets, FRC operates a much smaller footprint with roughly 80 offices focused on the urban coastal regions of the U.S. FRC’s key markets include San Francisco, Los Angeles, San Diego, New York, and Boston, focusing on high net worth (HNW) households in those markets. 90% of FRC’s earnings are from commercial banking (consumer and business banking) and 10% from wealth management. As of 3Q21, FRC had $173bn of assets, Assets Under Management (AUM) of $250bn, and generated $1.3bn of net income over the prior four quarters.
FRC’s unique business model
Since FRC’s second IPO in 2010, the bank has grown loans by 20%/yr., AUM by 29%/yr., net income by 16%/yr. and EPS by 12%/yr.
FRC’s client service-oriented culture, and hyper focus on servicing HNW households in urban coastal markets, has been the key driver of FRC’s strong performance. Most people don’t associate strong customer service with the banking industry, and FRC has stood out. Specifically, FRC’s 2% annual customer attrition rate is 75% lower than the 8% industry average. FRC’s low customer attrition and focus on HNW relationships allows FRC to maintain a smaller branch network, leading to higher assets and deposits/branch relative to peers. Furthermore, long-time FRC customers have many products with the bank. When FRC last reported this metric in its 2015 10K, FRC sold an average of 8 products per new loan client, although that number has likely declined due to the growth in new household relationships. Nevertheless, this illustrates how sticky customer relationships are with FRC.
Additionally, FRC’s NPS score of 73 is more than double the U.S. Banking Industry Average and above other companies with strong reputations such as Southwest, Ritz Carlton, and Apple.
FRC’s client focus is driven by its relationship managers (RM’s) who act as the single point of contact for FRC’s clients and remain the key point of contact for the duration of a client’s relationship with FRC. This is a key differentiator compared to FRC’s peers, where consumer banking clients rarely have a single point of contact and frequently deal with automated customer service phone numbers or unhelpful digital assistance. Relationship Managers are ultimately responsible for delivering excellent customer service by working across the organization to deliver the appropriate products and services for clients.
FRC has also structured the RM compensation to incentivize customer service and strong underwriting. Specifically, RM’s are paid based on each client’s entire banking relationship, including products and services such as wealth management. Additionally, RM compensation includes a credit clawback provision where the RM is responsible for loan performance throughout the duration of the loan. If a loan goes bad, the RM must pay FRC back an estimated 4-6x the compensation paid for originating the loan! As a result, RM’s have much greater incentive to ensure conservative loan underwriting and effectively to treat FRC’s money as their own. This unique provision has helped drive FRC’s exceptional credit performance, which is discussed further below.
FRC also compensates support personnel based on client’s overall experience with the bank, and FRC recently increased its minimum wage to $30/hr. As a result of its strong culture and strong compensation, FRC has experienced minimal employee turnover, with average voluntary employee turnover of just 7% from 2016-2020. Additionally, 91% of loans originated at FRC since 1985 are from bankers who are still with the bank.
FRC’s client-oriented culture has resulted in strong loan growth from existing clients and from client referrals. Notably, 88% of FRC’s new loans from 2015-2020 were from existing clients and client referrals, with only 12% from entirely new clients.
In addition to strong growth through existing relationships and referrals, FRC has more recently launched several programs aimed at younger households. These include the Household Debt Refinance, which has attracted 31.5K households and $2.2bn of loans, and the Professional loan program, which has attracted 6.4K households and $2.1bn of loans. FRC now has over 37K millennial households, a more than 8x increase since 2015, which now represent ~1/3 of FRC’s consumer borrowing base. As these households age, their financial needs will become more complex, allowing FRC to sell them additional products and services such as mortgages, HELOC’s, wealth management, etc.
Furthermore, I expect FRC to exhibit strong growth in its existing footprint and add new attractive markets over time. From 2003 to 2019, FRC experienced a more than 6x increase in HNW relationships, from 16K to 117K. However, FRC’s market share only increased from 3% to 5%, as FRC’s markets increased their HNW households, and FRC expanded into new markets.
FRC’s core markets are quite strong and should continue to create many HNW households, as they outperformed the U.S. overall by 19% since 2010, based on FRC’s proprietary economic index. Additionally, these markets contain 60% of all U.S. HNW households, despite containing only 21% of overall U.S. households, and this concentration has increased by 30% since 2003.
For context, recent new markets include Boston in 2005, Portland in 2007, Palm Beach in 2011, and Jackson, WY in 2019. Furthermore, FRC could expand to additional markets such as Austin, Dallas, DC, Philly, as existing relationships may move to lower cost areas of the country. Management recently noted that through the increased use of technology the bank can better serve clients who move out of its core markets.
FRC also grew its wealth management business at a strong clip with AUM up 29%/yr. over the past decade. As a result, wealth management revenue increased from 8% of FRC’s total revenue in 2012 to 17.5% in 2020. AUM growth has been driven by strong markets, cross-selling efforts, and attracting wealth management teams from other firms to First Republic. Specifically, when Credit Suisse exited U.S. private wealth management in 2015, many former CS teams moved over to First Republic, and have stayed at the bank since then. Additionally, I expect FRC to gather assets from its recently acquired millennial households as they grow their relationship with First Republic.
Finally, FRC tends to show less cyclicality than peers, as evidenced by 68% loan growth during the Financial Crisis (2008-2009), and more recently, with 24% loan growth in 2020, and up 14% this year through 3Q21. This compares to most banks showing declines in loans during the Financial Crisis and minimal loan growth in 2020 and 2021.
Conservative Balance Sheet
The other key differentiator for FRC is the bank’s extremely conservative balance sheet with minimal credit losses over time, and strong capital ratios.
In terms of FRC’s credit quality, FRC has had by far the lowest level of credit losses in the sector. Specifically, FRC averaged 4bps of net charge-off’s (NCO’s) from 2000-3Q21, compared to 37bps for the top 50 U.S. banks. Effectively, FRC’s NCO’s in 2009 at the height of the financial crisis were basically an average year for most banks over the past 21 years!
FRC’s remarkably low credit losses are driven by FRC’s incentive programs and a focus on real estate lending in its core markets. As noted above RM compensation is tied to loan performance over time, and executive compensation is also tied to asset quality (discussed below). Consistently, the bulk of FRC’s loans (80%) are collateralized by real estate in its core markets, with 60% of FRC’s loans for single-family residences/HELOC’s, 12% multifamily, 7% commercial real estate, 13% business loans, and 6% other. 89% of FRC’s residential loans are within 20 miles of an FRC office with 37% in SF/Valley, 20% LA, 19% NY, 8% Boston, and 4% SD. FRC’s modest business loan portfolio is diversified across 59% PE/VC, 25% non-profits, and real estate, investment firms, aviation/marine, professional services.
Given its focus on HNW households, FRC’s median single family residential loan is for $800,000, with an LTV of 59%, a borrower FICO score of 778, with $618,000 of liquidity. Similarly, FRC’s median multifamily loan is for $1.7mn with an LTV of 55%, and the median commercial real estate loan is for $1.6mn and an LTV of 45%. As a result of these conservative characteristics, FRC’s borrowers rarely default on their debt.
Amazingly 91% of FRC’s loans since 1985 have been originated by bankers who are still with the firm. Additionally, 70% of FRC’s loans were originated by bankers with 10+ years with FRC, and 29% of loans originated by bankers with 2.5-10 years of experience at FRC. This stability also aids in credit quality, as bankers have long-term relationships with clients can work closely with clients to resolve any delinquent loans.
Strong Capital Ratios
FRC has also maintained capital ratios well ahead of regulatory minimums set by the Federal Reserve, with a 9.61% Common Equity Tier 1 (CET1) Ratio compared to a required ratio of 7%, given FRC’s size. Additionally, FRC maintains a Tier 1 Ratio of 11.99% compared to a minimum required ratio of 8.5%, and a Total Capital Ratio of 13.16% compared to a required minimum of 10.5%. As shown below FRC’s capital ratios have been consistently strong and above requirements over time. FRC typically operates with two years of excess growth capital, as a conservative measure to avoid reliance on capital markets during times of stress.
Return on Equity consistent but middle of the pack
From 2015-2020 FRC generated an average ROE of 11%. Given FRC’s strong growth, and conservative underwriting I was surprised that FRC’s ROE has consistently been in the middle of the pack compared to other large banks since 2015. Although FRC’s ROE has been much less volatile than its peers, driven by no exposure to cyclical businesses such as Debt and Equity Capital Markets, as well as no major regulatory fines, and minimal credit losses.
So why isn’t FRC’s ROE higher?
The key driver is the fact that FRC generates only 15% of its revenue from fee income compared to 40-50% for the money center banks and large regional banks. Many of these fee sources of income (Asset Management, Wealth Management, Capital Markets), have low or no capital requirements compared to commercial banking, leading to higher ROE’s. For example, JPM’s Asset & Wealth Management segment generated a 27% ROE from 2016-2020, while BAC’s Wealth & Investment Management segment generated a 24% ROE during that time frame. JPM’s Corporate & Investment Bank averaged a 16% ROE during that time frame.
In terms of the other major earnings drivers such as Net Interest Margins (NIM), and cost structure, FRC’s performance is generally in-line with peers.
NIM higher than money center banks, in-line with regional banks
As of 3Q21, FRC reported a NIM of 2.67% which is well above the money center banks in the 1.6-2.0% range, and in line with large regional banks in the 2.5-2.75% range.
FRC’s NIM is substantially higher than for the money center banks, as excess liquidity at the money center banks acts as a drag on their NIM’s. For example, JPM earns 0.09% on its deposits with banks, and 1.32% on its investment securities, compared to 3.99% on its loan portfolio.
Impressively, FRC has generated strong NIM’s despite no exposure to higher risk/higher yielding lines of business such as autos, cards, and subprime lending. For example, ALLY earns 6.6% on its retail prime auto loan portfolio (inclusive of new and used cars), AXP earns 11% on its credit card portfolio, and subprime auto rates are in the 11-14.5% range, compared to FRC, which earns 2.75-2.8% for single family mortgages, 3.25% for Multifamily loans and 3.5% for Commercial Real Estate (CRE) loans.
Cost structure has increased over time
FRC’s core efficiency ratio increased from 56.2% in 2010 to 62.3% in 2020. This was driven by higher compensation as a percent of revenue, offset by a decline in non-compensation expense as a percent of revenue. Specifically, comp. as a % of revenue increased from 28% in 2010 to 38% in 2020, due to continual hiring and substantial increases in FRC’s minimum wage paid, which now stands at $30/hr. Additionally, FRC’s incentive approach to growth in AUM, deposits, and loans as noted above, makes FRC’s comp. expense much more of a variable expense, and much less fixed in nature.
FRC currently targets an efficiency ratio between 62-64%, in-line with most large banks. Efficiency ratios for the money center banks range from 55-70%, while the large regional banks range from 58-68%.
Management noted on the 2Q21 earnings call that the pandemic has led to lower travel related costs, and FRC’s non-comp expense as a % of revenues declined from 27% in 2019 to 24% in 2020. However, I don’t expect FRC to experience much operating leverage going forward outside of a modest reduction in travel expense and slight improvements in efficiency as clients are more open to shorter digital meetings, rather than longer face to face meetings. While many of FRC’s larger peers are highly focused on cost cutting due to weak loan growth, FRC is still growing its business at a very high rate and continues to invest in the business.
As Jim Hebert noted on the 2Q21 earnings call:
“This is a growth enterprise, and we're basically focused on the quality of delivery of service at the same time. So operating leverage can be achieved by cost cutting, which others do. We're not in that game. We're in this for the long haul.
It's a very long game. And so, our approach has always been to maintain, as Mike just said so clearly, a balance of operating costs and invest continually in operating systems and procedures so that we have good backup and safety embedded. But -- so operating leverage is not -- it's on the table, but it's not our primary objective. Quality of delivery of service is a primary objective.
And then we grow, and we grow because the clients grow. As Gaye has said, 75% of our growth is driven by our clients or their direct referrals…… So what we value, above all else, is stability, the predictability and stability of the model. And that's a balance, that's a continual balance. So I wouldn't actually look for the company to have a lot of operating leverage.”
FRC’s founder and long-time CEO, Jim Herbert will remain Chairman and Co-CEO until 12/31/22, after which Mr. Herbert will remain the Chairman. He will be replaced by Co-CEO Gaye Erkan as the sole CEO. Gaye Erkan joined First Republic in 2014 as Chief Investment Officer and Co-Chief Risk Officer, was promoted to President of First Republic in 2017, and was appointed to the bank’s board of directors in 2019. She was appointed Co-CEO earlier in 2021 and has long been considered Mr. Herbert’s replacement. Prior to working at FRC Ms. Erkan worked at GS in a quantitative capacity from 2005-2014.
In terms of the transition, I expect Ms. Erkan to continue following FRC’s successful formula of continuing to take market share among HNHW households in coastal urban regions, with conservative underwriting and a strong focus on customer service and maintaining the company’s culture. I don’t expect FRC to expand into riskier lines of business, or to lower its underwriting standards.
FRC’s executive compensation is tied to asset quality (30%), regulatory criteria (30%), and profitability ROA (20%), ROE (20%). 93% of the CEO’s pay and 91% of the Named Executive Officers (NEO’s) pay in 2020 was variable and performance based. Per FRC, this mix of compensation incentivizes strong financial performance while ensuring that FRC complies with all applicable and regulations and does not take on undue risk in its underwriting. As noted above, FRC has maintained peer-leading credit metrics, and this is supported by FRC’s executive compensation practices.
FRC has issued equity over time to fund its strong organic growth, with equity issuance diluting EPS by ~400bps/yr. since 2010. FRC also pays out around 14% of net income in dividends.
Additionally, FRC has made several modest acquisitions over time, primarily in its wealth management business:
• Acquired Luminous Capital in 2012
• Took a minority stake in Nigro Karlin Segal & Feldstein in 2013
• Acquired Constellation Wealth Advisors for $115mn in 2015
• Acquired Gradifi in 2016, a provider of student loan debt, and then sold to E-trade for $30mn in 2019.
• Took a minority stake in Common Bond in 2018
• Took a minority Stake in The Promise Homes in 2021
Going forward, I expect FRC to continue issuing equity to fund internal growth and paying a modest dividend. I don’t expect FRC to pursue large scale acquisitions given its strong organic growth and acquiring another bank would be dilutive to FRC, given the bank’s unique culture, including its strong underwriting performance.
Interest rates remain low
Like other banks, FRC’s earnings have been hurt by the low-rate environment. FRC even more so than its peers as it derives 85% of its revenue from net interest revenue, and only 15% from fee income compared to roughly 50%/50% mix for FRC’s peers. FRC’s core NIM declined from 3.61% in 2010 to 2.67% as of 3Q21, a 26% decline.
While rates have increased as of late, with the 10-yr. UST at 1.64% as of October 25th, rates are still at the lower end of the historical range. I do expect rates to rise modestly from here, as the market has priced in several Fed rate hikes over the next couple years, but I don’t anticipate FRC to be a major beneficiary of higher rates. Importantly, FRC has modest interest rate sensitivity as to shorter term shocks as shown below. Even if rates were to fall, it would take several years to have a large impact on FRC’s profitability.
The key idiosyncratic risk for FRC is the retirement of founder and Co-CEO Jim Herbert at the end of 2022. While Jim’s replacement seems more than capable, transitions from founders can be challenging for many businesses. As noted, Gaye Erkan has extensive banking experience at both GS and FRC, and I believe has shown to be a competent leader thus far. Additionally, I believe she has been groomed for this role and has been the clear successor for several years now. At this point in time, it’s too early to say what type of impact Ms. Erkan will have or what types of strategic changes will be made. Nevertheless, this is a risk to monitor going forward.
Revenue growth: My base case is for 16.1% annual revenue growth from 2022-2026 driven by 14% loan growth, a slight increase in FRC’s NIM from 2.68% in 2021 to 2.85% in 2026, and a 15% increase in fee income from strong AUM growth.
Expense growth: I expect expenses will increase by 16.3%/yr. through 2026, with FRC’s efficiency ratio stable at 63% over that time frame, in-line with management’s guidance.
EPS growth: I expect 12.1% annual EPS growth driven by 15.4% net income growth offset by 3.3% annual dilution.
FRC trades at a premium valuation to large U.S. banks, which I believe is justified based on its superior track record of value creation, strong growth, low risk business model, and conservative balance sheet. FRC currently trades at 26x ’22 EPS compared to 14.4x for JPM, 15.3x for BAC, 14.5x for USB and 15.5x for PNC.
In terms of expected returns, with no change to FRC’s multiple FRC would generate a 13% IRR through 2026 driven by 12% annual EPS growth and a 0.44% dividend yield. While this is an attractive base case for a stable and fast-growing business, I believe there is meaningful downside given FRC’s premium valuation. Expected IRR’s drop to 8% over the next 5 years, if FRC’s forward P/E multiple declines to 20x, which still represents a large premium to most U.S. banks. As a result, for now I’ll remain on the sidelines and wait for a more attractive entry point.
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions. You can follow Enlightened Capital on twitter here!