The banker of Silicon Valley's tech and finance industries reported that its earnings soared 85% year over year to $274.8 million in the third quarter. Despite beating Wall Street analyst expectations on the bottom line, shares of SVB Financial (NASDAQ:SIVB) were battered in active trading on Friday, dropping more than 12% on the day.

Below, we'll go through the ups and downs of SVB Financial's third-quarter report.

SVB Financial's third quarter: By the numbers

This bank holding company primarily makes its money as all banks do, by taking in deposits, making loans, and providing services for which it earns fee income. The table below includes some key metrics for the bank. Pretax income was included to show its change in earnings power on a basis that isn't affected by a lower corporate tax rate in 2018.

Metric

Q3 2018

Q3 2017

Year-Over-Year Change

Net loans

$27.2 billion

$21.9 billion

24%

Deposits

$48.6 billion

$44.8 billion

8%

Pretax income

$376.7 million

$251.5 million

50%

Net income

$274.8 million

$148.6 million

85%

Diluted EPS

$5.10

$2.79

83%

Data source: SVB Financial.

Given the significant reduction in corporate tax rates for 2018 versus 2017, it pays to look at changes in pretax earnings to get a better feel for a company's growth. Note that pretax earnings increased by about 50%, whereas after-tax profits (net income) increased at an 85% clip year over year. A lower tax rate is doing a lot of the heavy lifting in driving outsize profit growth for U.S. banks this year.

Federal Reserve Building.

Image source: Getty Images.

What happened this quarter

There were a few themes during the quarter that should get more attention from investors. 

  • Rising rates didn't help much this quarter. SVB Financial is supposed to be one of the most asset-sensitive banks you can buy, meaning its profits should increase as interest rates increase. This quarter, SVB Financial reported a net interest margin (NIM) of 3.62%, up only modestly from a NIM of 3.59% in the sequential quarter and 3.10% in the year-ago period. Net interest margin is a measure that shows the difference between what a bank earns on its assets (loans and securities) compared to what it pays on its liabilities (deposits and other borrowings). On the conference call, management noted that NIM would have been about 3 basis points higher (3.65% vs. actual of 3.62%) if not for some shorter-term borrowing at higher rates during the quarter.
  • Deposit growth slowed. One question for SVB Financial has been whether it can continue to bring in deposits despite paying a lower-than-average rate to its clients. This quarter, the bank reported that average deposits grew just 2.3% quarter over quarter to $49 billion. In contrast, average client funds held off balance sheet grew 11.6% quarter over quarter to $79.6 billion. (Client funds held off balance sheet primarily includes money market and short-term bond funds its clients use to earn a higher return on excess cash.) The bank is selectively looking for ways to offer higher yields to some of its clients to encourage them to bring their balances into a deposit account versus an off-balance-sheet investment account. All else equal, SVB earns more money lending out deposits than it does from managing its clients' cash in off-balance-sheet products.
  • Credit quality remains excellent despite an uptick in charge-offs this quarter. During the quarter, the bank had an annualized net charge-off ratio of just 0.30% of loans, up from 0.22% sequentially and 0.19% a year ago, but still well below the banking industry average. All banks have bad loans, but SVB Financial has had very few. The bank set aside $17.2 million for loan losses this quarter, down from $29.1 million last quarter and less than the $20 million of net charge-offs this quarter, which suggests either that it expects credit losses to decline or that it may have to set aside more money for losses in future periods.

What management had to say

SVB Financial doesn't just bank red-hot start-ups, it's also a leading banker to the venture capital and private equity funds that invest in them. As a result, the bank's results largely ride the tailwinds of the tech and financial industry in Silicon Valley, which has, by almost any measure, been red hot.

In prepared remarks on the conference call, SVB Financial's CEO, Greg Becker, said the following:

At $84.3 billion year-to-date, U.S. venture capital investment has already exceeded 2017 levels and is approaching all-time highs. U.S. VCs have raised $32 billion, putting 2018 on pace to exceed 2017 and marks the fifth consecutive year of fund raising in excess of $30 billion. The expansion of global private equity industry has been dramatic and sustained. In Q3, there were more than 3,000 private equity funds raising capital, a 52% increase over a year ago, and dry power reached a record high of $1.1 trillion.

For perspective, roughly half (48%) of gross loans outstanding at the end of the third quarter were loans to venture capital and private equity funds. These loans are truly its bread and butter, generating attractive yields despite the fact that loan losses have been few and very far between.

Competition was a common theme on the third-quarter conference call. In response to an analyst's question about the competitive environment, Becker said that there was increased competition across the board in the third quarter.

I would say there was an increase in competition in the third quarter and it kind of makes sense like we've listened to other earnings calls out there from banks and there wasn't a lot of growth. And so usually what you see happening if people are struggling for growth, they start to be as aggressive as they possibly can be from a pricing perspective. That's the first thing that goes. We've seen that for the last obviously several years, but I would say there was a slight uptick in that competitive side on lowering pricing in the third quarter. And to be honest that's probably going to continue, right. Again, the outlook that you saw from other institutions was very, I'd say, generally anemic growth.

Of course, banking is inherently competitive, but SVB Financial's focus on high-growth start-ups and the Silicon Valley financial community likely gives it an edge against the thousands of plain-vanilla banks competing for business loans. There are more than 4,800 commercial banks in the United States, but SVB is one of the few that is focused almost entirely on the technology industry.

Looking ahead

SVB Financial sees its rapid growth in 2018 moderating somewhat into next year. On the conference call, management outlined its preliminary guidance for 2019, which is summarized and compared to its guidance for 2018 in the table below.

Line Item

Expected Percentage Growth in 2018

Expected Percentage Growth in 2019

Average loan growth

Low twenties

Mid teens

Average deposit growth

Low teens

High single digits

Net interest income growth

Mid thirties

High teens (without rate increases), low twenties (with rate increases)

Core fee income growth

Mid thirties

Mid teens

Noninterest expense growth

Mid teens

Mid teens

Data source: Conference call commentary and earnings release.

The company is still very much in growth mode, something that seems to have taken Wall Street analysts by surprise. Note that even as SVB Financial's guidance calls for slower revenue growth in 2019, it still expects its expenses to grow at roughly the same pace in 2019 as they did in 2018.

SVB Financial provides credit and banking services to The Motley Fool. Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends SVB Financial Group. The Motley Fool has a disclosure policy.