The Inoculated Investor

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Playing the Devil’s Advocate
A Report on Synovus Financial (SNV- $1.92): 12/18/09 Usually the act playing the devil’s advocate involves taking a contrarian position. So, in the case of a stock that is trading at about $2, down from over $30 in 2007, presenting a pessimistic outlook for the stock might not seem particularly bold or unique. However, Tom Brown from bankstocks.com recently wrote a bullish piece on Synovus Financial (SNV) that argued pretty persuasively that the bank was undervalued at the current price, based on some reasonable assumptions about future earnings. Brown also contends that the bank likely has sufficient capital to survive the credit cycle without diluting shareholder further by issuing shares. While I do not necessarily disagree with his overall thesis that SNV has the potential to be one of the survivors, based on my analysis of the bank’s capital position and credit trends I do not agree with Brown’s assessment of SNV’s near term prospects. Specifically, the data I have analyzed continues to highlight some troubling developments in the bank’s loan book that could eventually force the company to raise new capital and could impair earnings for many quarters to come. Clearly, being an investor with a long time horizon, short term issues should not influence my opinion of the stock as long as I believe the company will make it through alive. Therefore, let me start off by addressing each one of Brown’s arguments and then close with what I think it all means for the long term. Point 1: “The worst-performing loan portfolios have begun to shrink. In any major credit cycle, different loan categories will have vastly different default frequencies and loss severity. For Synovus, the worst portfolios, both in frequency and severity, have been (by product type) loans to homebuilders and (by geography) loans in the Atlanta metro area and in Florida.” Brown is spot on when he points out that the residential construction book, especially in Atlanta and in Florida, has been SNV’s worst performing portfolio. As of Q3 2009, $507.5M of this $2,513.3M book was classified as nonperforming. If an NPL ratio close to 24% (up from 19.2% in Q2) sounds high that’s because such a rate would have been unfathomable just 3 or 4 years ago. Fortunately for SNV, the size of the 1-4 family construction and development portfolio and its potential impact on earnings has begun to shrink. Specifically, this portion of the book was down to $2,513.3M ( 9.5% of the total book) in Q3 2009 from $2,963.6 (10.7% of the total book) in Q2. Also, given how early the southeast portion of the US began to experience the housing bust, it is likely that many of these construction loans have experienced the bulk of the writedowns they will cumulatively see. However, in my view, problems with construction loans represent only the first wave of writedowns and losses for SNV and the other regional banks. The second wave, which consists of prime mortgage defaults, commercial real estate writedowns and losses on C&I loans, is just starting to play out. In particular, when combined with the lack of consumer credit and substantial unemployment, the negative derivative impacts of the housing crisis are really starting to impact other types of businesses and loans. Take a look at the following chart and you can see what I mean:
Q1 2009 Net Charge Offs: Non-Accrual: 1-4 Family Construction Other Construction & Land Total Construction/Land Farmland 1-4 family Mortgage Multifamily Nonfarm/Non-residential Mortgage Non-Accrual Tied to Real Estate Total Non Accrual
Source: FDIC.gov

Q2 2009 $355.0 $209.8 548.5 $758.4 2.8 175.7 17.6 275.3 $1,229.8 $1,378.8

Q3 2009 $497.0 $166.6 606.9 $773.6 2.0 192.6 12.7 397.4 $1,378.3 $1,469.8

$246.0 $231.8 419.3 $651 3.8 131 13.5 258.3 $1,057.6 $1,214.7

I compiled the above data from the FDIC’s website and it only includes loans classified as non-accrual (total nonperforming assets also includes other real estate owned and loans 90+ days past due and still accruing interest). Now, the bank has disposed of some underperforming loans and this may be skewing the data a bit, but I believe the trend is clear. We can see increasing net charge offs (to be addressed more later on) and increasing non-accrual

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loans in the following portfolios: construction, 1-4 family residential mortgage and nonfarm/non-residential mortgage (commonly known as commercial real estate mortgages). I think this data definitely corroborates what Brown is arguing in point number one. Non-accrual loans in the 1-4 family construction book were down to $166.6M in Q3 2009 from $231.8M in Q1 2009. But look at the close to 50% increase in non-accrual loans having to do with other construction and land. Also look at the dramatic increase in 1-4 family mortgage delinquencies and in commercial real estate non-accruals. This represents the second wave of delinquencies that I believe are going to keep credit losses elevated, require SNV to continue to build its reserve, and ultimately require additional capital. Point 2: “The inflow of new nonaccrual loans will continue to slow.” I addressed this point above but will say a few more words here. Since the company is on pace to sell $600M in troubled assets during Q3 and Q4, it is important to look at new additions to non-accruals and not just the change in balance between one quarter and the next to evaluate whether there has been an increase or decrease in problem loans. Brown estimates that additions to non-accruals will only be $650M in Q4 2009 versus $756M in Q3 2009. Apparently, these beliefs were confirmed on his recent trip to visit the management team. Unfortunately, if this does occur I believe it will only be a temporary reversal based on the fact that while construction NPLs will continue to decrease, that reduction will eventually be more than offset by new problem loans in other categories. Also, I am having trouble assessing the impact of this change, but it looks like SNV may have moved the goal posts a bit in terms of classifying NPLs. From the Q3-2009 10-Q: “During the third quarter of 2009, Synovus revised its definition of nonperforming loans to exclude accruing restructured loans. Such loans are not considered to be nonperforming because they are performing in accordance with the restructured terms. Management believes that this change better aligns our definition of nonperforming loans and nonperforming assets with the definition used by our peers and therefore improves the comparability of this measure across the industry. All prior periods presented have been reclassified to conform to the new presentation… Accruing restructured loans were approximately $193 million at September 30, 2009, compared to $18 million at June 30, 2009. At September 30, 2009, the allowance for loan losses allocated to these accruing restructured loans was approximately $29.7 million.” (Emphasis added) Now, the company does not give a lot of additional info on these restructured loans, but from what the national data on housing-related re-defaults tell us (up to a 70% rate when modifications only include interest rate changes), these may be some of the riskiest loans in the portfolio. If all $193M of these loans were classified as NPLs then total NPLs would increase by 11% and companies allowance to NPL ratio would look even more insufficient. Point 3: “The level of net chargeoffs should start to decline.” The first reason that Brown states for a potential decline in NCOs is that he believes that new non-accruals will be down quarter on quarter. According to Brown, the company takes an immediate 15-20% haircut on non-accrual loans in the form of a charge off. So, if new non-accruals are down so too will NCOs. Since we obviously have differing opinions on this I will move on to the next point. Second, in Q3 SNV wrote down existing NPLs by $135M and Brown makes the valid point that it is unlikely that the bank will take such a large hit on existing bad loans again in Q4. When you combine cumulative writedowns and specific reserves associated with each loan, SNV has allowed for a 46% cushion (Brown uses 42% as his figure but the Q3 2009 10-Q claims the number is 46%) that should be enough to limit significant writedowns in existing NPLs. However, the company plans to complete its sale of up to $600M in problem assets (including other real estate owned) by the end of Q4 and that may cause SNV to recognize losses before it would have if it had held onto the loans. Specifically, in Q3 the company recognized $76M related to charge offs on loan sales. Unfortunately SNV does not break out what portion of the $339M of assets sold was loans and what portion was OREO so it is hard to estimate exactly the magnitude of the writedowns on each. However, it is important to note that whatever the percentage is, it is likely in addition to the initial 15-20% hit the bank takes when a loan gets classified as nonaccrual. Also, since SNV may be unable to sell the most distressed assets, the assets sold in Q3 may have been somewhat cherry picked and the associated writedowns may not accurately represent the overall losses embedded in the portfolio. In fact, based on the $600M target of asset sales SNV will likely have to realize additional losses on the $261M in assets remaining to be sold in Q4 and NCOs may not actually decline at all.

The Inoculated Investor

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In any case, under the assumption that SNV is eventually going to have write off existing dodgy assets whether it sells them or not, a temporary postponement of NCOs in a single quarter should not influence the overall analysis of the company’s long term value. Point 4: “The level of OREO writedowns should also start to decline. Synovus had $606 million of credit expenses in the third quarter, including an unusually high $101 million in OREO expenses. OREO writedowns should decline for three reasons. First, new nonaccrual loans moving into OREO have been written down to lower values than in prior periods. Second, the company will be less aggressive in OREO disposition. Finally, loss content of future OREO dispositions will be lower than in the past because properties being disposed of now tend to include more income-producing properties and less land than they did before.” I surmise that Brown is correct on this assumption, barring a huge spike in foreclosure activity in Q4 2009. But, as pointed out above, if the company is going to eventually have to write down OREO to the lower of cost or fair value, the timing of the writedowns is not particularly important to someone who wants to buy and hold the stock. Plus, I am concerned that the number of foreclosures stemming from commercial real estate loans and 1-4 family mortgage defaults are going to keep OREO costs elevated and negatively impact earnings. Point 5: “Loan loss reserve building has slowed and will soon stop; reserves will begin to be drawn down next year.”

“Not only do we expect this to continue but, next year, as more loans are upgraded, we believe the company will begin to bring its loan loss reserve (3.5% of total loans) down by provisioning less than its quarterly level of net chargeoffs.” This is where I think I disagree with Brown the most. The idea that SNV does not have to continue to build its reserve seems unfounded. Going back to the first chart that shows the persistent increases in non-accrual loans, I cannot see a justification for SNV solely matching its Q3 provision to net charge offs. A conservative ratio of allowance for loan losses to nonperforming assets is 100%. This means that for every $1 of NPAs, the bank sets aside $1 for potential losses. While this may be unnecessarily cautious in some cases, it looks to me like SNV may be under-reserved. Take a look at the following chart:
Provision for Loan Losses NCOs Provision Provision to NCO Ratio Allowance Allowance for Loan Losses Allowance to NPAs
Source: Company reports

YTD $1,098.0 $1,418.5 129.19% Q2 2009 $918.7 53.47%

Q3 2009 $497.0 $496.5 99.90% Q3 2009 $918.5 52.56%

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As of Q3 2009, the ratio of the allowance to NPAs was only about 52.6%. Keep in mind that one of the reasons this number did not decrease even further was that SNV sold $339M in troubled assets and subsequently took large losses on those sales. In particular, new non-accrual loans in Q3 were $756M and the company (on net) did not increase its reserve accordingly. Even worse, the quarterly provisioning for Q3 did not even cover the NCOs recognized in that period, a fact that indicates to me that SNV is barely keeping its head above water. These actions are not indicative of a conservative management team that is being realistic about potential future losses. My theory is that the bank is actually concerned about its capital levels and does not want reduce its common equity even further by increasing the allowance for loan losses. Also, under-provisioning allows the company to report higher earnings (or less negative earnings) than it would otherwise. It is in situations like these that I like to create a proforma valuation for a bank under the assumption that it had an allowance to NPA ratio of 100%: This table shows what multiple to book and tangible book SNV would be trading at if it matched its allowance to actual NPAs. This is a conservative way to evaluate banks, but in the current Total NPA 1747.5 economic environment an analysis like this is a necessity. In Difference -$829.0 comparison to the multiples to stated book and tangible book of .29x and .30x, respectively, under this scenario the multiples Stated Total Assets $34,610.50 jump to .47x and .49x. Also, gross loans to tangible equity (a Stated Net Loan Book $25,413.2 measure of leverage) spikes from 12.2x to 19.9x and the Tangible Common Equity $2,154 company’s tangible equity to tangible assets (TE/TA: a measure Common Equity $2,211 of capital sufficiency that I put above all others) drops from 6.23% to 3.93%. Bank analysts look for TE/TA levels at or Increased Reserved 829 above 5%, especially for banks that are seeing their loan books Adjusted TCE $1,325 deteriorate. This is a perfect example of how underAdjusted CE $1,382 provisioning and not recognizing losses can make a bank look Gross Loans/TE 19.9x healthier than it really is. I can’t say for sure that SNV’s P/TBV 0.49x management team is being too optimistic, but this analysis P/BV 0.47x suggests that (especially given the continued increase in nonTE/TA 3.93% accrual loans) SNV may be forced to raise new capital if it wants to have a sufficient buffer against future losses.
Q3 2009 Pro Forma B/S Stock Price: $1.92 $918.5 Allowance for Loan Losses

“Given our forecast for improving credit, declining credit costs, and modestly improving pre-tax, pre-credit cost earnings, we expect manageable operating losses and a modest decline in the company’s capital ratios before they start to sharply improve in the second half of 2010 and in 2011. Under this scenario, we do not expect a dilutive capital raise!” In addressing the capital issue, Brown includes a chart that highlights a few of the bank’s capital ratios. However, I do not put a whole lot of stock in Tier 1 ratios and claims of being “well capitalized.” How many banks were considered “well capitalized” the day before the FDIC walked in and shut them down? This is precisely why I like to look at TE/TA and leverage ratios such as Gross Loans/TE to get a handle on capital sufficiency. Based on these metrics I do not believe SNV currently has strong enough capital levels for potential investors to be comfortable. To make matters worse, Brown indicates that he expects the capital levels to actually decrease even further, partially offset by some balance sheet shrinkage and gains from asset sales. Honestly, I am not sure what he is referring to when he asserts that SNV will realize gains from asset sales. Unless the company is planning on selling off profitable business lines, it appears that sales of loans and OREO are actually leading to significant losses and further capital destruction. Future Earnings Analysis Now that we have finished assessing the balance sheet, it is necessary to look at future earnings and the income statement. The truth is, no matter how ugly balance sheet is, if the SNV can survive the cycle (and even if it does have to raise some more capital) and get back to somewhat normal earnings levels, the stock at the current valuation may be very attractive. From Brown: “Assuming the company turns profitable in the third quarter of next year, its initial earnings will be taxfree. Then after a few quarters of profitability, the company will be able to reverse its deferred-tax asset

The Inoculated Investor

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reserve, which today totals $331 million. This would boost the company’s capital ratios by around115 basis points and boost tangible book value by 70 cents per share, or 15%... Given this [estimated] level of income [$685M], $160 million of “normalized” credit expenses, a full tax rate, no TARP preferred dividends, and 490 million shares outstanding, we see normalized EPS of 70 cents per share. Assuming a below-historical normal P/E multiple of 12 times, we see the stock trading between $8 and $9 over the next two to three years, making it a potential five-bagger from today’s stock price.” First, I am far from an expert on deferred tax assets and loss carry-forwards, but if what Brown says is correct the future tax savings could be substantial. I am not sure how to handicap this since it is hard to know what the next few quarters will look like in terms of profitability. As mentioned above the level of provisioning is a huge factor in determining whether or not a bank is profitable in a given period. Accordingly, I would rather focus on what SNV could be worth in a more normal operating environment, given that the company survives this credit cycle. Brown estimates that normalized EPS are in the $.70 range and if a 12x multiple were applied to those earnings the stock could be worth between $8 and $9 dollars. On a similar note, here is my analysis based on pre-tax pre provision/credit losses earnings (eloquently known herein as PTPPE):
Pre Tax Pre Provision Earnings Net Interest Income Non Interest Income Non Interest Expense PTPPE Shares Outstanding PTPPE per Share Closing Stock Price P/E Multiple Provision for Losses Foreclosed RE Expense 2004 $860.7 1521* 1588.4* $793.3 310.3 $2.56 $28.58 11.18x 75.3 0 2005 $965.2 327.4 646.8 $645.8 314.8 $2.05 $27.01 13.17x 82.5 0 2006 $1,125.8 359.4 764.5 $724.0 324.2 $2.23 $30.83 13.81x 75.1 3.3 2007 $1,148.9 389 803.3 $750.3 329.9 $2.27 $24.08 10.59x 170.2 15.7 2008 $1,077.9 396.6 986.3 $624.9 329.3 $1.90 $8.30 4.37x 699.9 136.7

*Includes revenues and expenses from payment processing that were not present post 2004 Source: Company filings and my calculations

In the above chart I calculate PTPPE by adding net interest and non interest income, subtracting non-interest expenses and adding back foreclosed real estate expenses. Over the last 5 years the average PTPPE per share was $2.20 and the average multiple that the stock traded at in relation to that figure was 10.62x (clearly dragged down by 2008 data). The reason I am not trying to estimate EPS like Brown did is because it is very difficult to make any meaningful assumptions about future credit losses and foreclosed real estate expenses. Just look at the disparity between the provision as recently as 2006 and the full year provision for 2008. Having said that, it is important to be careful not to extrapolate the bank’s current issues too far into the future and to make sure to keep in all that the government might do in the coming years to help boost bank profitability. Based on my assumption that the company should increase its allowance by about $830M to be safe, to get TE/TA back up to 5% SNV would have to raise an additional $375M in capital. At $2 a share, that implies an increase in shares outstanding of 187.5M, bringing the total to somewhere around 520M. From there, assuming a conservative run rate PTPPE of $625M implies per share earnings of $1.20. If the company ever traded at 10x that amount the stock could eventually get to $12. Of course, it could take years for a normalized scenario to play out, especially given my expectations of future credit losses, but the analysis of earnings does indicate that Brown may be on to something with SNV. Now, I have to temper the optimism a little bit with the following data. I use a basic guideline for valuing the appropriate multiple of book value for bank as follows: a bank that earns a return on common equity (ROCE) of 10% should trade at 1x book value and a bank that earns an ROCE of 20% should trade at 2x book value. While SNV has been able to achieve a strong net interest margin (NIM) over the years, the bank’s ROCE has not been particularly noteworthy:

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Historical Returns NIM ROCE ROA Efficiency Ratio

2004 4.22% 17.90% 1.90% 52.10%

2005 4.18% 12.80% 1.40% 49.80%

2006 4.27% 12.50% 1.40% 51.20%

2007 3.97% 9.60% 1.10% 54.50%

2008 3.47% -18.50% -1.70% 64.90%

5 Yr Avg. 4.02% 6.86% 0.82% 54.50%

Source: Capital IQ and my calculations

Specifically, even if the poor results from 2008 are omitted from the data, the average ROCE for SNV over the boom years of 2004 to 2007 was only 13.50%. This would imply a fair book value multiple of only 1.35x. However, as is shown below, SNV over that same period traded at much higher multiples to book value:
Historical P/E 2004 2005 2006 2007 2008 Current 5 Yr Avg. Average Multiple 19.43x 19.11x 16.47x 15.52x 14.16x NM 16.94x Historical P/Tang. Book 2004 2005 2006 2007 2008 Current 5 Yr Avg. Average Multiple 3.91x 3.97x 3.50x 3.15x 1.15x 0.30x 3.14x Historical P/B 2004 2005 2006 2007 2008 Current 5 Yr Avg. Average Multiple 3.28x 3.20x 2.79x 2.52x 0.97x 0.29x 2.55x

Source: Capital IQ and my calculations

I think these lofty, growth-like multiples were indicative of irrational exuberance among investors when it came to banks. People got caught up in the potential for balance sheet and earnings growth due to all of the population growth-induced new lending opportunities in the southeast and western portions of the US. But now that balance sheets and earnings are shrinking, unless you view banking as a no risk, money printing business, it is hard to justify a bank that can only generate a 13.5% average ROCE during a boom trading at 2.55x book. Thus, this data does not indicate to me that SNV should go back to trading at 2.5+ times book when the credit environment becomes more normal. So, if we apply a fair multiple of 1.35x to an estimate of future book value, we can get a more realistic idea what SNV may be worth in the coming years. Based on my current fair book value of $1,382M (after adding $830M to the allowance), adding an additional $375M in equity from issuance of new shares, incorporating a 10% additional reserve build to account for future losses (meaning that the bumped up reserve will not be enough to last through the cycle), and taking into account about 520M shares outstanding results in an estimate of book value per around $3.00
Current Adjusted BV (+) Additional Equity Capital (-) Additional Reserve Future BV Shares Outstanding BVPS 1.35x Multiple 2.55x Multiple $1,381.7 $375.0 $174.8 $1,582.0 520 $3.04 $4.11 $7.76

These calculations clearly do not entail as much potential upside as the earnings analysis. Even if the stock traded at the 2004-2008 average multiple of 2.55x, the stock would only be worth about $7.75. Having said that, with the stock around $2 today and even with the assumption of massive additional dilution, the resulting $4.00 stock price in a few years still would represent meaningful appreciation. Therefore, analysis of both the balance sheet and income statement lead to the conclusion that if SNV is able to make it through the cycle without being sold in a distressed transaction or taken over by the FDIC as a result of being undercapitalized, shares are likely to trade much higher in the coming years. Unfortunately, this conclusion is

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dependent on a number of assumptions that could prove to be woefully incorrect. First, there is no way to know if the bank will need to raise capital, how much it will need and how dilutive the share issuance will be based on the stock price at the time. Next, because of the difficulty in anticipating the direction of unemployment, housing prices and general economic trends, estimates of future credit losses are likely to be unreliable. Finally, applying historical rates of returns and multiples in trying to establish intrinsic value is, at best, an imprecise method of valuation. Furthermore, there are plenty of company-specific risks as well. The bank could have to raise substantially more capital than I have estimated. The capital markets could be essentially shut down at the time SNV recognizes the need for additional capital and could subsequently become essentially insolvent. Management does not appear to be publicly acknowledging the continued deterioration in the loan portfolio or the spike in non-accruals in second wave categories such as commercial real estate and C&I loans. I fear that that some of the under-provisioning that appears to be going on is based on the hope that the real estate markets begin to turn around as the economy shows preliminary, but very tenuous signs of recovery. When combined with my suspicion that the company is loathe to issue more shares and dilute current shareholders further, this extend and pretend philosophy could be very dangerous. In conclusion, an investment in SNV is not for the faint of heart and anyone interested in accumulating shares would be wise to follow the company very closely. If you cannot already tell, my experience with the management teams of regional banks has led me to be very distrusting and skeptical of any and all pronouncements or forecasts. The people who run these banks have an incentive to downplay current and future problems because in the end banking is business built on trust. Additionally, with the Federal Reserve handing out money and the yield curve so steep, it is easy to see why banks would try to extend and pretend in an attempt to earn their way out the cycle. Accordingly, it is more important to monitor the actions of the bank in terms of recognizing losses, adding to reserves and selling off troubled assets than to rely on the claims of management. From my perspective, I would be inclined to hold off from investing in SNV until management either acknowledged the need to raise capital and/or started to increase its reserves again. I believe that current investors are likely to be substantially diluted through additional share issuance and new investors would be better served being patient. However, assuming the bank’s franchise has not been severely impaired and SNV ultimately raises enough capital to make it through the cycle, I think there is a legitimate possibility that the shares could double over the coming years.

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