First Republic: Built For The Tough Times

We came across First Republic Bank (NYSE:FRC) earlier this year as we read through earnings calls transcripts and were genuinely surprised by this gem of a company. On the back of another excellent quarter, it seems a good time to have a look at the company to examine what makes it so good. We find that the bank has limited exposure to risky sectors, a well-off clientele base, a high-quality loan portfolio, and an experienced and committed management team. We balk at the valuation and the risks that lie ahead in terms of the uncertainty brought about by Covid-19 that may bring with it increased credit losses as some customers default.

Let us explore this bank in detail.

Built on a strong foundation of customer focus

First Republic is a commercial and trust bank based in San Francisco, California. It specializes in providing services like private banking, real estate lending, and wealth management services to clients in certain metropolitan areas in the US. It is based on a simple but unique business model that is focused on excellent client service with a heavy personal touch. This has seen it get 75% of its growth in clients through referrals from existing clients. Amazon (NASDAQ:AMZN) CEO Jeff Bezos once stated that the “number one thing that has made us successful by far is obsessive-compulsive focus on the customer.” Here is a bank that epitomizes that principle to the full. The client is at the center of its flywheel. Comes as no surprise then that its motto is “it’s a privilege to serve you.” Even we feel like opening an account there! The high customer satisfaction rate added to the strong referrals, and a very low attrition rate is its model for success.

Founded in 1985, the bank has been profitable in its entire lifetime. It has experienced some tremendous top-line and bottom-line growth in the past five years with tangible book value and revenues growing at a CAGR of 15% and 16% respectively over the period 2013 to 2018 as per the 2019 report. The bank has been performing exceptionally well over the past decade and continues to impress with its strong performance despite the current pandemic. The bank’s goal is built for these tough times as explained by CEO James Herbert in Q1 2020:

We tried to build a very strong vessel to go through a storm, and we believe we have, and we will find out fairly soon, but we believe we are in very good shape…we will not wake up with a capital too low under any circumstance

A strong quarter showcases FRC’s solid financials

FRC delivered another excellent quarter with a Q2 EPS of $1.61, beating expectations by $0.23. Revenue came in at $1.06B, a +19.68% YoY increase and a $61.5M expectations beat. Moreover, net charge-offs for Q3 were only $1.7 million ($3 million YTD), and at quarter-end, non-performing assets were only 0.12%!. The bank managed to grow total loans and total deposits by 19% and 22% yoy respectively in a pandemic. For your information, this was its best quarter ever in loan originations. Stock market appreciation and net client inflow have also seen the total wealth management assets grow. Furthermore, the bank had an 11.4% growth in net interest income this quarter and has had a stable net interest margin over the years. This kind of growth while spectacular is hard to sustain going forward given that we are in the midst of an uncertain time. What can be worrying also is that NIM and ROE have been declining over the past few years which could be attributed to the declining general interest rates.

Source: Koyfin

FRC has a strong balance sheet with strong capital ratios, with Tier 1 capital ratio coming at 8.38%. It shored up its capitals this quarter with a $500M of qualified Tier 1 fixed-for-life-perpetual preferred. In short, the bank has managed to retain a solid balance sheet with healthy credit, capital and liquidity ratios, and an excellent top and bottom line even in these tough times.

Source: Q3 Report

While several banks, especially in Europe, are reducing returns to shareholders by cutting dividends or stopping share repurchases, FRC has declared a $0.20 per share dividend to common shareholders. In 2019, FRC paid a dividend of 0.75 USD, a 5.63% YoY increase. This is its ninth consecutive year of dividend increases.

Source: Q3 Report

A high-quality loan portfolio

The bank has a longstanding and ongoing focus on assembling a high-quality credit portfolio with low LTVs and high credit scores. High-quality portfolios are very important in stressful environments like the current one where loan defaults are bound to increase. The first casualties in such times as these are banks with poor portfolios and high exposures to highly impacted sectors. Around 80% of FRC’s loan portfolio was real estate collateralized which has a loan-to-value ratio of 57% overall. Its client base is young urban professionals with an average FICO of 7.70, an average income of over $200,000, and more than 85% of whom have graduate degrees. These are very high-quality borrowers. The real tests for this loan portfolio will be in Q4 as some of the deferrals expire, but we are confident that the medium to long term looks good.

The bank has always aimed to underwrite zero losses with a focus on one loan at a time. It has stringent standards that it will not compromise on to win business. The key is also maintaining a close relationship with clients and knowing when they are facing distress and helping them through it. It has local knowledge of the client epitomized in the fact that 90% of all its real estate loans to customers who reside within 20 miles of one of its offices.

How are its clients doing in these stressful times, one might wonder?

At quarter end, the dollar amount of loan modifications totaled 3.7% of the total portfolio. As a reminder, most of our modifications were made in April and May with an initial duration of 6 months. Therefore the deferrals are scheduled to expire during the fourth quarter. We expect the vast majority of our clients to return to normal payment at that time, and early indications are quite positive – President Gaye Erkan

The bank’s competitive advantage is in high-quality service and building strong relationships with clients. The focus is on building close and deep relationships with clients which helps it be aware of any changes in customer circumstances. Uniquely, 90% of its loans, since 1985, were originated by bankers still with the bank. It has been in crises like this before and has handled them well:

Our approval process for new loans is the unique partnership between credit trained bankers who knows their clients very well and their seizing credit approvers who know our select markets very well underpinned by a callback provision that’s been in place since 1986…This has gotten us through a number of challenging times including the early 90s, the dot com burst, the ’08, ’09 great recession and while we don’t know exactly how this pandemic will play out, we feel confident in the system and in the strength of our loan portfolio.” – Chief Credit Officer David Lichtman [Q1 2020]

Limited exposure to risky sectors

The pandemic has brought about quarantines, regional lockdowns and social distancing which have negatively impacted sectors like travel, hospitality, entertainment and tourism. FRC is different in that it has limited exposure to these highly impacted sectors. The bank generally provides no lending to oil and gas companies, airlines and most travel-related businesses. A significant majority of its clients are in the legal, healthcare and finance industries. Those are industries that are poised to perform well in this pandemic. To be specific, retail and hotels make up less than 2.5% of its portfolio. This small portion had an average loan size of under $3 million, a median loan size of only $1.5 million, a weighted average LTV of 50%, and a debt coverage ratio of two times, which is nothing short of impressive.

When the pandemic started, there was a general awareness from many banks that a storm of loan defaults could hit them anytime, which is why they built up reserves over Q1 and Q2. In line with other banks, FRC had $48 million in reserves in Q1, which was ~3.4X Q1 2019. The notable thing so far is the lack of increases in provisions from then on. JPMorgan (NYSE:JPM) and Citigroup (NYSE:C) that have reported earnings so far are not seeing an increase in delinquencies. Similarly, FRC has actually reduced its provision for credit losses from Q1 to Q2 and Q2 to Q3. Provision for Q2 was $31 million and Q3 was reduced further to $28.5 million (vs. $16.7 million for last year).

What you’ve seen with us and also the other banks this morning, I mean, provisions are a bit lower than they had been the early part of the year, which I think is what CECL was intended to have happen when things start to improve. You’re right, our losses have been very low – CFO Mike Roffler

The challenges that lie ahead are the current poor visibility on what is coming and how long this pandemic will last. The defaults may come and all one can do is to identify good companies that can weather the storm. We strongly believe FRC is one of these companies. Be aware of the risk in rising non-performing loans in the year ahead which will still remain until a vaccine is found.

any losses that may come out of that, it’s likely going to be in the 2021 calendar period versus something that pops here in the fourth quarter – Mike Roffler


The stock has retraced its losses from back in March and is now trading at an all-time high price. The premium valuation does reflect the quality of the bank though. It is currently trading at a PE of ~21.8X and a P/Book of ~2.2X. This is above the industry P/B average of 0.68 and a three- and five-year historical average of 2.12 and 2.152. For a bank with a high efficiency ratio, low credit risk, and high liquidity and capital, the valuation seems justified. With such high valuation multiples, although we love the company and the stock and would love to own it, our bullishness and love for the bank tempered. As such, we choose to keep it on our watchlist waiting for better entry points though.

Source: YCharts

Interestingly, the bank was in the portfolios of 37 hedge funds as of the end of June. Several hedge funds also added to their stakes in FRC during the March lows of Q1. For instance, TRUE Private Wealth Advisors, Allred Capital Management and Price Wealth acquired stakes in FRC while Valeo Financial Advisors and Advisors Asset Management increased their holdings.

Source: Insider Monkey via Yahoo Finance


Our view is that this is a bank that is built for tough times given its high-quality portfolio, a strong credit quality history, and a lack of exposure to currently risky sectors. That it is trading at a premium to peers is a reflection of its high quality. There is a lot of room for growth heading into Q4, and as such, we would be keen on initiating a foothold in this premium jewel to benefit. There are risks of course as the credit losses may mount as the corvid-uncertainty keeps weighing on banks. We will keep an eye on these risks in rising non-performing loans and charge-offs in the next quarter.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FRC over the next 72 hours. 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.

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