SVB: Market Uncertainty Creates Investment Opportunity

By John Loesch, CFA
July 2016
“In an environment in which banks are struggling to grow revenue, SVB enjoys a unique model that generates growth rates at multiples of peers.”

The last year has seen investors grapple with a number of concerns, including the health of the global economy, the future path of interest rates, the state of the technology sector, and most recently, Brexit. Such uncertainty often leads to market volatility and creates investment opportunities for long-term investors. SVB Financial Group (SIVB), parent company of Silicon Valley Bank, is one such opportunity.

Founded in 1983, SVB is a truly unique banking franchise primarily focused on the innovation economy. Over the last 33 years, the company has grown from a single office in San Jose, California to offices around the globe in key cities that are hotbeds of innovation. SVB’s focus, experience, and expertise make it the partner of choice for technology and life sciences companies. In 2015, 57% of all venture capital-backed technology companies and 42% of life science companies that went public were SVB clients.

SVB’s track record of growing intrinsic value over the long term and across various market environments is impressive. Using the growth in tangible book value per share as a proxy for intrinsic value growth, it has compounded at 15% annually for the last 10 years. The company accomplished this despite the headwind of low interest rates pressuring net interest margin1—a primary driver of bank revenue—which has declined from 7.4% to 2.7%. More impressive is that SVB averaged 14% tangible book value growth for the rolling five-year periods that include the recent financial crisis and 20% for the five-year periods that include the tech bust of 2000.

Tangible-Book-Value-per-Share2

In an environment in which banks are struggling to grow revenue, SVB enjoys a unique model that generates growth rates at multiples of peers. Despite continued net interest margin pressure from low interest rates, SVB’s net interest income is projected to grow in the mid-teens in 2016, even assuming no additional help from the Federal Reserve raising rates. While most banks are struggling to grow fee revenue due to declining deposit charges and slower mortgage banking, SVB is projected to grow fee income in the mid-20’s, highlighted by robust growth in foreign exchange and credit card fees.

Uncertainty about the future path of interest rates was a key driver of the decline in SVB’s stock from July 2015 to February 2016. With primarily variable rate loans on the asset side and non-interest bearing deposits on the liability side, SVB is one of the most “asset sensitive” banks in the industry. This means its assets reprice more quickly than its liabilities, benefitting net interest income in a rising interest rate environment. Investors brought down expectations for the path of interest rates due to fears about the global economy, impacting many of the asset-sensitive banks such as SVB. While rising rates will certainly be a benefit to SVB, the company has proven its ability to grow net interest income revenue despite the dramatic decline in net interest margin, as illustrated in the chart below.

160720_Industry-Perspective_Loesch_Net-Interest-Income
Source: SVB Financial Group, Q1 2016 Corporate Overview and Financial Results, May 2016

With nearly 50% of its loan book directly related to the innovation space, fears surrounding the health of the technology sector have been another driving force of uncertainty in SVB’s shares. Seemingly weekly stories about declining valuations for the tech “unicorns”—start-ups that have achieved a $1 billion valuation— fueled deteriorating market sentiment. More specifically to SVB, an increase in non-performing loans in the second quarter of 2015 caught investors by surprise.

While the health of these sectors is certainly important and something we monitor closely, we believe fears of a material credit event at SVB are overblown. First, the recent increase in non-performing loans was off an unusually low base and well within management’s guided range for normal. Management has been quite candid about their expectations for near term credit migration. Second, SVB’s business has little reliance on the largest “unicorns” whose valuation declines have spooked investors. Instead, SVB depends more on new company formation, which is still healthy. Despite the turmoil in the stock market and capital markets broadly in the first quarter of 2016, venture capital fundraising was at the highest pace in 15 years. Lastly, though loaning money to early-stage venture companies certainly carries more credit risk, the way SVB structures these loans helps offset this higher risk. When making early-stage loans, SVB also receives warrants in the companies, giving the bank the right to acquire equity in the businesses. Many of these warrants expire worthless, but the warrant gains taken over the years have outstripped the credit losses in early-stage companies (see chart below). Further, the proportion of riskier early-stage loans has declined over time, from 14% of gross loans in 2007 down to 7% in 2016, as SVB has grown other lines of business.

Market prices are clearly more volatile than intrinsic values. SVB shares traded over $150 per share in July 2015 and declined to below $80 in February 2016. That decline brought the company’s price/tangible book value multiple down from 2.5x to less than 1.5x. We regularly evaluate our estimates of intrinsic value based on current information and do not believe the shift in economic expectations, a lower future path of interest rates, or the health of the tech sector impacted SVB’s intrinsic value nearly as much as the movement in the stock would suggest. Short-term movements such as these create opportunities for investors with long-term perspective to invest in great franchises like SVB Financial at attractive prices.

160720_Industry-Perspective_Loesch_Gains-on-Equity2
Source: SVB Financial Group, Q1 2016 Corporate Overview and Financial Results, May 2016

1 Net interest margin measures the difference between what a bank earns on its assets (loans and securities) and what it pays on liabilities (deposits and borrowings).

Originally published on July 21, 2016

The views expressed are those of the research analyst as of July 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

 

>>>>