The Rate Also Rises

This article is part of a short series of articles on strategic movements among regional banks. Among these articles, I may feature specific banks or call out trends. I have no relationship with any of the banks I will highlight, though I have spent time working at a large commercial bank. I will note when I hold a position in a company or ETF or plan on taking a position.

The Rate also Rises

SunTrust Banks, Inc. (NYSE:STI)

Market Cap ~ $21B

In my prior article, I discussed what I see as a growing trend in the commercial banking business. The trend towards what I call universal regional banks is fascinating because it calls to mind the trends of the 1990s and early 2000s in commercial banking. I find it highly likely that the better-managed, larger regional banks expand their businesses and brands to gain a national presence. Some may do this out of a desire for growth and scalability. Others may do it because they view this as mandatory for survival. Either way, strategic consolidation will likely result from the competitive pressures of the current market climate and long standing industry headwinds.

An archetypal example of the consolidation process among regional banks is Bank of America (NYSE:BAC) in the 1990s and 2000s. The process often occurs as follows: A regional bank grows through strategic acquisitions of regional banks and brokerages when they are weakened. This regional bank becomes a universal regional bank with a large regional retail banking presence, a strong commercial banking franchise, and a robust middle market investment banking practice. When opportunity knocks, a well managed universal regional bank has the opportunity to save the day by acquiring poorly run commercial banks or investment banks and gain the scale necessary to compete with the money center banks.

The growth from regional to super-regional to universal regional, to universal bank might seem slightly far-fetched for some of the candidates I will discuss in this series, but not that long ago, Bank of America and Wells Fargo (NYSE:WFC) were regional banks headquartered in small cities. Bank of America is still headquartered in Charlotte.

This brings me to the first regional bank I will analyze that has transformed its model into a universal regional bank: SunTrust Banks, Inc. (STI)

SunTrust has been steadily strengthening its consumer and commercial banking divisions over the last several years. Last quarter, the bank holding company efficiency ratio continued to improve with a full year 2014 target of 64% and a long-term run-rate efficiency ratio of 60%. SunTrust made major improvements in efficiency over the last 6 quarters, and we see SunTrust as being serious about maintaining efficient operations. The 60% level is a reasonable target for a deposit reliant commercial bank, and while we might contend that there is still likely room to improve the efficiency ratio by reducing costs, we agree with management that the best drivers of improving the efficiency ratio remain improving the top line.

In terms of growing revenues on the consumer lending business, there are several drivers to consider going forward. SunTrust will most obviously benefit from rising rates. They currently have low cost deposit bases which has been a driver of net interest margin (NIM) improvement in many commercial banks over the last 2-3 years. SunTrust will be a major beneficiary as rates rise and banks can drive higher net interest income.

Rising rates will likely stifle the mortgage refinancing market over the next several years. The broad effects of this are several: SunTrust will not have as much loan originations, resulting in less fees for originations and for selling off guaranteed loans. However, SunTrust, like many other banks, has been the victim of refinancing on their held for investment (HFI) loans. As such, SunTrust will likely see lower pre-payments of mortgages, but also lower non-interest income than it has seen over the last six quarters. Overall, the negative effects of rising rates will likely be somewhat muted, but definitely seen in the mortgage book as mortgage behavior begins to normalize to a new run rate level.

All of this said, these predictions are at the mercy of Federal Reserve policy and as such, SunTrust has no control over them.

Sunny-side Up

There are, however, levers of growth that SunTrust management has a bit more control over. Many of investment banking activities are not nearly as interest-rate reliant. Over the last several months, SunTrust has been making significant efforts to strategically grow its wholly-owned investment banking subsidiary, SunTrust Robinson Humphrey (STRH). SunTrust Robinson Humphrey is a full-service corporate and investment bank that focuses on middle market companies. SunTrust has grown its corporate and investment bank in a relatively organic manner over the last several years, noticeably ramping up that process over the last six months by making several important hires.

While SunTrust can improve the overall firm’s efficiency ratio by growing its investment banking division, the growth of a strong investment banking division can also strengthen its commercial and consumer businesses. By bolstering its credentials as a universal regional bank, SunTrust can strengthen its brand regionally and introduce it to the national scene.

The reduction in investment banking activities among the large money centers and universal banks has led a renaissance for boutique investment banks (e.g. Moelis (NYSE:MC), Evercore (NYSE:EVR), Centerview, etc.) and the rise of small kiosk firms (e.g. Paul J Taubman). The role filled by regional middle market investment banks is at risk of being hemmed in by the bulge-bracket firms and squeezed by small boutiques. However, I believe that universal regional banks have the opportunity to maintain and even gain share in the middle market space through focused thought leadership in specific industries.

SunTrust Robinson Humphrey seems to have taken this strategy to heart by spending the last several months bolstering its equity and debt capital markets, sales & trading, and research divisions through strategic hires across the United States (herehere and here). Indeed, SunTrust Robinson Humphrey has expanded far beyond the footprint of the retail bank. How long until the commercial bank expands to meet the needs of clients in the investment bank? How long until the retail footprint follows?

Suffice to say that with recent growth in SunTrust Robinson Humphrey, executives at SunTrust are signaling their ambition to create a full-service bank within the company’s current footprint. Not only does SunTrust have the potential to scale nationally, executives may have the ambition to do so as well.

Overview and Caveats

One key factor I have not yet mentioned, but that one should consider when evaluating SunTrust is the bank’s capital ratios. SunTrust is currently well capitalized as of June 30, 2014, with a Tier 1 common equity ratio of 9.72%, Tier 1 capital ratio of 10.66%, and a total capital ratio of 12.53% (per the 10-Q filed 08/06/2014). Given the fact that SunTrust gained approval to double the quarterly dividend this year after the most recent CCAR process, the current levels of capital should position the bank strongly going forward with adequate capital to manage most market conditions.

The main headwind that I see as a potential near-term concern for SunTrust is a deterioration of loan quality in the auto loan book. Auto loans have become a major growth engine for regional banks over the last 2-3 years, as borrowing and repayment habits of American workers shifted after the Great Recession such that repayments of car loans became major priorities. Should customer payment habits change, this could create material financial issues for SunTrust and several other regional banks.

While I believe that there is decent upside in SunTrust, I would wait for the right price to buy shares of this business. I believe that SunTrust has the capacity to grow assets and footprint significantly over the next decade. The trick, as always with banking, is to do so profitably. After all, banks that simply dilute shareholders to create behemoths are rarely alpha generating investments. The past several decades have shown that while excellent banks can find economies of scale, poorly run banks that grow too large soon find themselves with crippling diseconomies of scale.

While the history of Bank of America may not repeat itself, I believe that SunTrust can rhyme. The question is not, however, can SunTrust become a universal regional bank, or even if it can become a national or international universal bank. The question that remains – can SunTrust do so profitably?

This article is an initiation of coverage. I will follow up with more fundamental analysis and valuation in a future article.

I hold no positions in STI.  I do not anticipate taking any long or short positions within the next 72 hours
I am not a Registered Investment Advisor.  This should not be considered investment advice. This is purely an expression of my opinions.
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