SVB Financial Group Is a Profit Machine, But Is It a Good Value?

Over the next month, banks will be releasing results for the second quarter. In advance of these releases, let's take a moment to review the state of some of these banks as of the end of Q1.

In this post, we'll take a look at SVB Financial Group (NASDAQ: SIVB  ) , a $297.1 billion bank headquartered in Santa Clara, CA. You can find information on other banks at my Motley Fool article feed, available here. All data in this analysis was sourced from the FDIC's Quarterly Banking Profile and S&P Capital IQ.

When I evaluate banks, I follow a model made famous by former Wachovia CEO John Medlin: Soundness, profitability, and growth. As investors, we then take a look at valuation and the potential for investment after gaining a better understanding for each bank.

Soundness refers to the bank's asset quality. Generally speaking, this means loans. If a bank makes loans that are never repaid, that bank will fail and fail quickly. The best banks put risk management first, ensuring that shareholder capital is protected if a portfolio of loans turns sour.

To measure this, we'll take a look at both non-performing assets and SVB Financial Group's provision for loan and lease losses. A simplified definition of non-performing assets are loans or other assets that have fallen seriously delinquent or are in foreclosure.

The provision for loan and lease losses is a reserve of money that the bank pulls out of its income each quarter to guard against future losses in the loan portfolio. Banks are required by regulation to maintain certain levels of reserves, but within that management has plenty of wiggle room to over or under reserve. Over reserving increases protection but hurts net income; under reserving increases risk but keeps net income high.

For the quarter ending on March 31, SVB Financial had 0.09% non-performing assets as a percentage of total assets. The FDIC reports that banks with total assets greater than $10 billion on average had 1.5% non-performing assets as a percentage of total assets.

SVB Financial reserved $490 thousand for the first quarter, which represented 0.1% of operating revenue. This compares with 5% for the $10 billion+ peer group, according to the FDIC.

SIVB Chart

Many investors misjudge SVB's operating model as being very high in risk. The bank's bread and butter is lending to venture capital backed start-ups and early stage companies. They lend essentially unsecured on many loans, taking intellectual property as collateral with questionable resale value if the company were to fail. On the surface, this does seem like a very, very risky proposition.

The reality though is that SVB is lending not just to the venture capital firm's portfolio company, but they are often times securing a guarantee from the VC firm itself. These firms are equity investors with upwards of hundreds of millions – if not billions – of dollars in capital. With that guarantee, and with the explicit backing of the VC firm, SVB is taking on far less risk than it first appears.

And that lowered risk profile is how the company can achieve such impressive soundness metrics.

After establishing an understanding of a bank's risk culture and soundness, next we can focus on profitability. Any investment in a business is an investment in that company's future earnings, so profitability is a particularly important consideration for any bank investor.

The first question, perhaps most obviously, is if the bank actually generates a profit at all. According to data from the FDIC, 7.3% of U.S. banks failed to generate a profit at all in the first quarter. That's one in every 14 banks!

For SVB Financial Group, the first calendar quarter of 2014 fortunately wasn't that bad. The company generated total net revenues of $506.5 million for the quarter – that is total interest income plus non-interest income subtract interest expense.

Over the past 12 months, SVB Financial Group has generated $1.6 billion in total net revenue. 39% of that revenue was attributable to net interest income, the difference between interest earned on loans and paid out to depositors. The remaining 61% was through fees, trading, or other non-interest revenue sources.

The bank was able to turn a profit margin of 17% on that revenue.

For the first quarter, the company reported return on equity of 34%. On a trailing twelve month basis, ROE was a still impressive 14%. Of the banks covered in this series of articles, the average return on equity was 8.9%. The FDIC reports that the average ROE for U.S. banks with total assets greater than $10 billion was 9.1%.

SIVB Profit Margin (Quarterly) Chart

Again, as a lender to VC backed start-ups, SVB's model is different than other, more traditional banks. The impressive ROE is a function of the company's high ratio of non-interest income to net interest income. Fee income doesn't require the bank to use any extra capital – its highly scalable, allowing the bank to generate high income relative to its capital base.

It's at this point we should probably discuss leverage. Leverage is a double edged sword for banks and could easily fit into either the soundness or profitability categories. We'll call it a subset of both and discuss it here.

Leverage is just part of the game with banks, so if you're a conservative investor who really focuses on conservative capital structures, the banking industry may not be the best place for your money. Adding leverage is an easy way to juice return on equity, which is generally speaking a good thing. The bank increases assets and thus earnings, while maintaining a lower capital level.

The result is a higher numerator, a constant denominator, and a larger return on equity number. The math does the heavy lifting for you.

On the flip side, too much leverage can put the bank on thin ice if the loan portfolio takes a turn for the worse. A stronger equity base protects the bank from bankruptcy and bailouts, two outcomes that are both politically charged and down-right terrible for shareholders.

Bank's use all kinds of esoteric and overly complex accounting methods to determine leverage. We'll keep it simple here with an old fashioned assets to equity ratio. The lower the number, the less levered (and more conservative) the bank.

SVB Financial Group's assets to equity ratio comes in at 8.8x. The average of the 62 banks analyzed in this series of articles was 9.1x.

SIVB Assets To Shareholder Equity (Quarterly) Chart

Note: Leverage appears higher in this chart due to YCharts excluding approximately $1.3 billion in capital held by non-controlling interests

Returning for a moment to SVB's ROE, it's unique that the company can achieve 30%+ returns in a quarter with below peer leverage. The reason is, again, that the company's primary revenue driver is fees and not capital intensive lending activities.

Growth and Valuation
SVB Financial Group saw its revenues change by 66% over the past 12 months. That compares with the average of the 62 banks analyzed of 5.7%.

This change in revenue corresponded with a 47% in net income over the same period. The peer set averaged 14.1%.

54% of all U.S. banks saw year over year earnings growth in the first quarter.

Moving now to valuation, SVB Financial Group traded at a forward price to earnings ratio of 24.8x according to data from S&P Capital IQ. This compares to the peer set average of 16.7 times.

SVB Financial Group's market cap is, at the time of this writing, 2.6 times its tangible book value. The peer set average was 1.9 times.

SIVB Price to Tangible Book Value Chart

Many investors use a general rule of thumb of buying a bank stock with the price to tangible book value is less than 0.5 times and sell when it rises above 2 times. For me, that method is just way too oversimplified.

It sometimes makes sense to pay a premium for a bank stock that places a high value on credit culture and asset quality. These banks will survive and prosper while others fall by the wayside. That security can be worth a premium. Likewise, a bank that relies heavily on leverage to achieve above average return on equity may not be worth the price, even if price to tangible book value is low. That risk may not justify even a healthy discount in price.

Based on the factors we've discussed here – soundness, profitability, and growth – SVB looks fairly valued. Yes, the company has amazing soundness metrics, and yes, the company's ROE last quarter was 3x other banks. And yes, the bank is growing like the proverbial weed.

However, there is a growing opinion that tech start up world where SVB plays is currently in a bubble period, and with a valuation of 25 times earnings, there seems to be more downside risk that future upside opportunity. SVB is a very, very good bank, but at this point in time the company's price does not represent a value in my opinion.

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