Profile: Bank OZK -- It's All About the NIM

New York | In this issue of The Institutional Risk Analyst, we assign a positive risk rating to Bank OZK (NYSE:OZK), f/k/a Bank of the Ozarks. We interviewed OZK founder George Gleason back in 2017. OZK is rightly seen as a bellwether for national commercial real estate (CRE) and also one of the best performing banks in the country. Significantly, Gleason predicts net runoff in CRE loan volumes in the US during 2021.

The $23 billion total asset regional lender is one of the more aggressive and better managed CRE players. They eat their own cooking in terms of retaining loans in portfolio. OZK dissolved its bank holding company in 2017 and is now a unitary state-chartered, non-member bank based in Little Rock, AK. This means the bank's sole federal regulator is the Federal Deposit Insurance Corp. Thus OZK does not appear in Peer Group 1, where it could easily figure in the top 10% of large banks about $10 billion in assets.

As the chart below illustrates, the bank has seen its price/book value multiple swing wildly in the past year, like much of the rest of the industry. The bank now trades at about 1.1x book vs around 1.8x for commercial lending exemplars such as JPMorgan (NYSE:JPM) and U.S. Bancorp (NYSE:USB).

Back in January of 2019, we wrote:

“Long one of the performance darlings in the US banking industry, OZK was known for being a well-run regional bank from Little Rock that had a big footprint in CRE lending nationwide. The common is off 50% over the past year, a reflection of some credit write downs that were not well handled with investors and an expensive name change and corporate name change and restructuring effort that leaves many puzzled.”

Financials Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, PYPL, SCHW, SQ, TD, TFC, USB, WFC

Over the past two years, the bank’s stock has certainly taken a beating with equity investors, resulting in an average market volatility or “beta” of 2 vs the broad market average of 1. But Gleason and his team remained entirely focused on lending and managing credit, and to good effect. Indeed, while many banks in the US have seen net interest margin (NIM) fall steadily due to QE, OZK has actually grown its gross loan spread and its NIM, placing them in a tiny minority of best performing banks led by American Express (NYSE:AXP).

Part of the reason for OZK’s strong performance in terms of NIM was the result of credit loss recoveries from charge-offs taken in earlier periods. But even excluding these one-time returns of capital in Q4 2020, OZK still managed to expand its gross loan spread even as the bank also managed credit losses well below industry averages. And it has basically done this for the past 20 years with great consistency.

“Our net interest income for the fourth quarter of 2020 increased for the third consecutive quarter and was a quarterly record $237.6 million, an increase of 10.5% from net interest income of $215.0 million for the fourth quarter of 2019,” the bank noted in its Q4 supplement. “Improvements during the quarter in our core spread and net interest margin, which increased from the previous quarter by 30 and 19 basis points (“bps”), respectively, were important factors in achieving this record net interest income.”

In Q4 2020, OZK’s gross loan spread on non-purchased CRE loans was 4.75% vs a cost of funds of 70bp. By comparison, JPM had a gross spread on all loans of 4.49% and the average for Peer Group 1 was 4.35%, as shown below.

Source: FFIEC

More important, however, is the insight that Gleason provided to investors regarding the outlook for bank lending in 2021 during his investor conference call. He noted during the OZK investor call:

“Well of course 2016 and 2017 were really large origination years which you know created a lot of pay-off headwinds in 2019 sort of you know two to three years after a lot of those big time originations and then we had you know got it last year that we expect that a lot of payouts in 2020, the slowing of completion of construction projects because of shelter-in-place orders and the slowing of the transition sort of financing, the bridge financing, permanent financing that takes us out clearly reduced payoffs and in the second quarters and third quarters of last year and pushed those out, we began to see quite a bit of that come back to the table in Q4 and will very likely have a record level of payoffs in 2021 in part because a bunch of payoffs pushed from 2020 to 2021.”

Reading between the lines, not only is OZK's Gleason expecting net runoff on its own commercial loan book in 2021, but we would also expect to see mid-single digit declines in all US bank commercial lending more generally this year. Given the current aggressive posture of the Federal Open Market Committee, we suspect that this will come as an unpleasant surprise to many people in Washington and especially at the Federal Reserve Board.

Although many banks saw the all-important operating efficiency erode in Q4, OZK instead improved efficiency and reported an efficiency ratio of just 38% at year end, more than 20% lower than JPM and the industry average of 61%. “Our efficiency ratio was 38.6%, and for the full year of 2020, it was 41.4%,” notes OZK. “Our efficiency ratio remains among the best in the industry, having now been among the top decile of the industry for 19 consecutive years.”

As with operating efficiency, OZK’s credit performance is also excellent and the bank has managed to outperform its own moderate scenario modeled forecasts for defaults and recoveries. OZK has also outperformed the Peer Group 1 and industry average by a wide margin, as shown in the chart below from the OZK Q4 2020 supplement.

By comparison, the net charge-offs for JPM in Q4 2020 were 55bp vs 28bp for Peer Group 1, thus OZK is running well-below these levels of net loss. The bank’s strong credit and recovery function have turned in consistently excellent performance year after year, a fact that ought to impress more investors and risk managers. It certainly impresses the savvy group that hold the bank's debt and equity securities. The chart below from the OZK supplement shows credit performance going back to 2009.

OZK notes that “in the Real Estate Specialties Group’s (RESG) 17+ year history, we have incurred losses on only a small number of credits, resulting in a weighted average annual net charge-off ratio (including OREO write-downs) for the RESG portfolio of 11 bps.”

Consistency means a lot. OZK has the capital, liquidity and earnings to continue to outperform larger banks. Our only question is whether OZK and all banks with a loan concentration in CRE are going to be able to manage the next 18-24 months, particularly in the market for underutilized urban commercial real estate. It's not about OZK or other banks mind you; it's rather about the excessive price volatility -- aka "inflation" -- injected into real estate markets by the FOMC and QE.

Assessment

We assign a positive risk rating to OZK because of the bank’s strong operating and credit performance over the past two decades. There was a time when OZK traded at a premium to the larger banks such as JPM and USB. True the stock is up 20% YTD, but that just means that JPM is trading close to 2x book vs OZK's 1.3x book as of today. But then again, nonbank mortgage issuer PennyMac Financial Services (NASDAQ:PFSI) is trading at 1.5x book today.

We always thought the name change to "Bank OZK" was a profoundly bad idea. But stylistic points aside, even though OZK did stumble in 2018 and thereby did damage to investor confidence, the bank continued to perform well despite the volatility in the stock. At some point, investors in US banks are going to take notice of this exemplary business and credit performance and reward Gleason and his team accordingly. Be well George.

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