SVB Financial Group: Head And Shoulders Above Its Peers – SVB Financial Group (NASDAQ:SIVB) No ratings yet.

Investment Thesis

Since its October 8 low of $188, SVB Financial Group (SIVB) has rallied 34%, and in the last twelve months the stock is up over 20%. With the market generally ignoring the financials sector, has this stock run up too fast?

I don’t think so. The entire stock price return has come from EPS growth in 2019. Trailing twelve-month EPS grew 41% (Q3 2019 vs Q3 2018), while the TTM P/E multiple is down nearly 2.0x to 11.8x.

Since this argument may seem a little unreasonable given that we have already crossed the fourth quarter of 2019 and are now less than a couple of weeks away from FY 2019 earnings (Jan. 23), let me use EPS figures from FY 2018 and FY 2019, but substituting consensus EPS value for Q4 2019 in the latter.

FY 2018 EPS

TTM P/E ratio

(on Jan 25, 2019)*

Consensus Q4 2019 EPS

Consensus FY 2019 EPS

Blended P/E ratio (on Jan 9, 2020)

$18.11

13.37x

$4.64

$21.31

12.01x

Source: Yahoo! Finance*January 25, 2019 is the day after the FY 2018 earnings release

From January 25, 2019, the stock rose just 5.7% (of course with high volatility in between due to three rate cuts from the Fed), yet we are looking at a “potential” EPS gain of nearly 18%. The P/E multiple is down 1.4x. In other words, with the entire financial services sector pretty much out of favor thanks to the three rate cuts, the market is ignoring SVB’s solid fundamentals.

I see three convincing reasons to own this stock today:

  1. Strong balance sheet growth driven by a solid net loan growth of 13% year on year, backed up by a diversified loan portfolio that lowers the risk of default,
  2. low deposit beta as non-interest-bearing deposits making up 65% of total deposits, and
  3. a move by management to reduce net interest income (NYSEMKT:NII) sensitivity to 10% in a low interest rate environment.

Strong balance sheet growth

SVB Financial grew net loans at an extraordinary rate of 16% annually over the last five years, and 21% annually since 2009. These figures are exceptionally good when compared to industry figures. The Federal Reserve reports that commercial and industrial loans at large domestically charted commercial banks grew from $977 billion to $1,281 billion in the last five years, or 5.6% annually. Over a ten-year period, average annual loan growth stood at just 6.8%.

Source: Federal Reserve St. Louis

While a little below its long-term average, net loans grew a solid 13% last year. SVB focuses it lending on mainly three areas: 1) lending to private equity and venture capital via capital call lines, 2) lending to Technology and Life Science/Healthcare companies, and 3) lending to private banking clients who are “primarily private equity/venture capital professionals and executive leaders of the innovation companies they support”.

SIVB - Diversified low risk loan portfolioSource: Corporate Presentation

Why I’m bullish about its loan portfolio and growth

There are two reasons to be bullish about this loan portfolio. First, SVB’s lending happens in non-traditional areas vs peers. Based on the above chart, it can be said that the bank is entirely betting on the innovation economy to bring about growth and profits.

According to Deloitte’s 2020 banking and capital markets outlook, “a new wave of disruption more forceful and more pervasive than what we have seen in recent years will likely unfold in the next decade”. This means banks in general will have to be transformative in order to stay relevant. The report says that in a low interest rate environment, asset growth (i.e. loans) will become a greater priority than deposit growth. And that’s where I think SVB’s unconventional loan portfolio betting on an innovative economy holds the edge against its banking peers. These lines of business are largely uncorrelated to the broader banking industry of retail, commercial and real estate lending which are facing headwinds in an uncertain economy.

Second, the loan portfolio is well diversified to reduce default risk. From September 2018, proportion of PE/VC lending grew five percentage points to 52%. This kind of lending happens via capital call lines of credit when private equity or venture capital firms take short term loans till their investors (limited partners) pay up for the capital call. From a bank’s perspective, these are low risk loans since they are collateralized by PE/VC firms’ ability to raise capital.

Within the same period, technology and life sciences/healthcare lending decreased by five percentage points to 32% of gross loans. This should diminish concerns over credit losses. In addition, early stage lending (the category that carries the greatest risk to credit losses) has fallen to 5% of the overall portfolio, from 11% in 2009 (see below graphic).

SIVB Loan breakupSource: Corporate Presentation

Below is a breakdown of gross loan growth in the first three quarters of 2019. While total gross loans grew by 9%, PE/VC lending grew a sound 15%. Management was prudent to keep lending to tech and healthcare startups constant.

Gross loans breakdownSource: Company data, author’s calculations

A word on PE and VC industry activity

According to Pitchbook’s annual US PE activity report, US PE deal-making activity last year “just fell shy of record-setting pace in 2018, with over 5,000 deals worth more than two-thirds of a trillion dollars”. That said, fundraising hit record highs in 2019, with over $300 billion raised despite a reduction in fund count. This should translate into plenty of opportunity for growth for SVB’s PE/VC capital call loan book.

PE activitySource: PitchBook

As a result, SVB’s client count has been growing at an annual rate of 15% since 2015.

PE-VC activitySource: Corporate presentation

Is there liquidity to grow further?

The answer is a resounding yes! Net Loans to Total Deposit ratio stands at 52% at the end of the third quarter. This is way below the 80-95% LDR for peers. This means that SVB Financial can further grow its loan portfolio by 55-80% with raising any more deposits, and still be in-line with peers! This, I believe is the ace that management can pull out anytime. Below is SVB’s LDR trend for the last ten quarters:

SIVB average loan to deposit ratioSource: Company data, author’s calculations

A safe haven in noninterest-bearing (NYSEARCA:NIB) deposits

SVB Financial has a very high concentration of noninterest-bearing deposits. About 68% of its deposit base is noninterest-bearing. The reason behind a high NIB deposit rate is because majority of the demands deposits belong the bank’s own clients who hold their operating cash balances with the bank. This should help create a far less drag on its net interest income and positions the bank better for a NIM expansion.

SIVB Percentage of noninterest bearing depositsSource: Company data, author’s calculations

A reduction in NII sensitivity

While a falling/low interest rate environment negatively affects Net Interest Income, management seems to be taking active steps reduce its sensitivity. As of September 30, 2019, management now expects NII to fall 9.7% for a 100bps fall in short term interest rates – a much better prospect than 11.7% drop modeled as in December 31, 2018 for the same fall in interest rates.

How is the bank achieving this? i) By converting variable rate loans to fixed rate using interest rate swaps. Notional outstanding, as such, has increased to $4.0 billion, up from $1.2 billion at the end of Q2 2019. ii) By using of products and pricing to reprice and shift excess deposits on or off the balance sheet over time, and iii) investing in fixed income securities with longer-term maturity (about 6 years) that would act as a hedge against short term interest rate fluctuations.

SIVB NII sensitivitySource: Corporate presentation

Valuation

Earnings growth has solely driven this stock higher in the past twelve months despite a shrinking price-to-earnings multiple. While traditional banking peers have struggled and as such has fallen out of the market’s favor in a low interest environment, the same cannot be said about SVB Financial. I believe earnings growth will continue to drive the stock. Using the (depressed) trailing-twelve-month P/E of 11.6x, even a conservative annual average EPS growth of 12% over the next three years would see SVB Financial trading at around $350 share price by the end of 2022 – a solid 38% upside. This is my base case. Should the market reprice the stock higher, say at 13x EPS, the stock should trade above $380 within a similar timeframe.

The risk to this view is an impending recession that could further shrink earnings multiple as the Fed would then likely bring down short term rates to zero.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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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