Description

Long NTB-$33.94

We believe the Bank of N.T. Butterfield (NTB) is an attractively valued high quality small cap bank that has 25% to 50% upside over the next year as investors gain appreciation for its business model. Trading at just 10x 2018 EPS with a 3.8% yield and generating a low 20% ROTCE, NTB is meaningfully undervalued on both an absolute and relative basis.  We believe that continued rate increases coupled with steady execution will drive consistent earnings growth resulting in modest multiple expansion-driving the stock to mid-$40s in a year from $33.94 today.    

We believe this opportunity exists because NTB screens as expensive on a P/B multiple, while the higher ROEs are dismissed due to a 0% tax rate.  Combine that with NTB being an offshore bank with only a $1.8bln market cap and this went in the too hard pile for many analysts when it came public.  

Company History:

The Bank of N.T. Butterfield is a Bermuda based bank that went public in September 2016 at $23.50/shr.  Currently the bank has a $1.8bln market cap and $11bln in assets. Founded in 1758, Butterfield has a long history in the Bermuda/Cayman region.  They have been public on the Bermuda stock exchange since 1994.  They required a recapitalization in the 2008 financial crisis due to ill-timed purchases of US MBS and a commercial loan provision.   They went public to raise capital to take out an expensive government backed preferred that was issued as part of the recapitalization in 2009.  Carlyle also became involved post recap and exited with the IPO and secondary.

Current management came in after the 08/09 financial crisis.  CEO Michael Collins has been in his current role since 2015 and has been with the bank since 2009.  Senior management owns a decent chunk of stock, with CEO Collins owning ~$20mln in stock, with only limited selling since the IPO.

Business overview:

We believe NTB’s business model is relatively low risk and can consistently generate attractive ROEs.

NTB is a traditional lender with a significant trust business serving high net worth families looking to set up trusts in Bermuda & Cayman.  Similar to the Hawaiian banks, NTB commands a very high deposit share in its core markets of Bermuda and Cayman of 39% and 35% respectively.   NTB generates 36% of its revenue from fee income, nearly half of which is of which is from its trust & asset management business which is incredibly sticky and provides a low cost deposit base.  The trust deposits are the main reason why NTB’s loan to deposit ratio is only 36%.  Unlike US banks, NTB’s residential mortgage portfolio (65% of loan book) is entirely variable rate. NTBs mortgage book is also very high quality with 80% under 80% LTV.  Credit risk is low in the mortgage book, while economic growth on Bermuda and Cayman is finally starting to recover from the effects of the financial crisis. The variable mortgage book results in NTB being very asset sensitive, (11% increase in NII for 200bps increase in rates).  This compares to the average US regional bank only seeing NII grow 2.8% for a 200bps increase in rates.

After going public last fall NTB is looking to expand its trust business thru selective acquisitions, though has yet to find anything to buy.  In 2016 they purchased HSBC’s trust business before they went public.  Trust acquisitions should be a growth opportunity for them as large banks are looking to exit the offshore trust market as it is usually a small business for them and requires significant compliance costs. Absent M&A NTB will build excess capital rapidly resulting in higher dividends and buybacks, with the goal of growing the dividend with earnings.

Excluding interest rate changes and M&A NTB believes they can grow EPS 8-10% annually with modest GDP growth while keeping the dividend payout around 50% of earnings.

As a result of being located in Bermuda NTB pays no income tax, this obviously helps to increase its ROE and EPS.  This is a permanent feature of the Bermudian economy and therefore should be capitalized, unlike a company with a finite NOL.  NTB also generates a very attractive ROA, which is indicative of the high market share they have in a concentrated banking market.  This implies the source of their high ROEs is not simply a 0% tax rate.

To summarize NTB has:

• High local market share (35-39% deposit share) compared to typical US regionals which operate in fragmented markets

• Allowing for a low 20% ROTCE-vs. 10-12% for most US regionals.

• Higher interest rate sensitivity (11% increase in NII vs 2.8% for a typical US regional for 200bps increase in rates)-while only having a 40% loan to deposit ratio.

• Higher mix of stable recurring fee revenue (36% vs ~23% for average US regional).

• Zero corporate tax burden due to being based in Bermuda.  

Valuation and Earnings outlook:

Assuming one more interest rate increase this year NTB should be able to earn $2.80 in 2017.  With another hike hikes in 2018 they should be able to earn $3.45. 2018 will be helped in part by the 90 day pricing lag on their Bermuda residential loan book, allowing the 2017 hikes to impact 2018.  By Q2 of next year TBV should increase from $12.50 currently to $14.60.  This does not assume any further trust acquisitions, or dividend increases.  Growth will be driven by NII increasing combined with deploying excess deposits into a rising rate environment.  I model fee income up modestly with little loan growth, consistent with recent trends.  Assuming NTB simply maintains its current multiple on both EPS and TBV they should be trading around $41 by next summer.

Rerating opportunity:

While NTB will likely always trade at a discount to US based peers given its offshore status, the discount should close over time as the market gets more comfortable with NTB’s risk profile.  Looking at other high quality mid cap banks and their relationship between P/TBV and RTCE imply that NTB should be trading north of 3x book and a mid-teens earnings multiple.

The chart below shows price to tangible book value vs return on tangible common equity for a large universe of regional/smid cap banks in the US.  NTB sticks out as undervalued given its return profile.

The most similar banking to NTB’s market in the US is the Hawaiian banking market, which is dominated by two regional banks, First Hawaiian and Bank of Hawaii.  Those banks generate mid to high teens ROE’s and trade ~2.8x book and a high teens P/E multiple.

Catalyst

Continued rate increases and quarterly earnings reports.  Later this year management is likely to raise the dividend to keep the payout ratio at 50% of EPS.