If you follow the banking sector, then I don't need to tell you that SVB Financial Group (SIVB +0.00%), the parent company of Silicon Valley Bank, has been on an absolute tear for more than a year. Before the pandemic, the bank traded at roughly $246 per share, a price it had earned after a long run of phenomenal performance. But the pandemic catapulted the tech and start-up banking powerhouse to the next level, and now SVB trades around $573. That's more than 350% of tangible book value (equity minus goodwill and intangible assets), which is a high valuation in banking.
At this kind of valuation, many investors might already be taking gains, or at least thinking about it. But I'm actually thinking the opposite -- I'm asking myself how high this stock can go, with significant upside in mind.
A lights-out quarter
While much of the industry struggled with high credit costs during the pandemic and is still struggling to find loan growth, SVB has been a different story. The niche bank pioneered start-up banking in the 1990s, and has been catering to the start-up, venture capital, and private equity communities ever since.
SVB provides short-term loans to private equity and venture capital companies so they can execute investments quickly. It banks early-stage start-ups, and is often able to obtain equity warrants at attractive valuations. It has an investment bank that specializes in the healthcare and life science sectors, does private venture investing on behalf of clients, and has a private bank and wealth management arm for higher-net-worth individuals.
Image source: Getty Images.
These businesses were at full strength in the first quarter of the year, as the bank followed a series of superb quarters with its best ever. SVB delivered net income of more than $532 million, or $10.03 diluted earnings per share (EPS), on total revenue of more than $1.4 billion. The bank's net interest margin, the difference between what it makes on interest-earning assets such as loans and pays out on interest-bearing liabilities, dropped to 2.29%, down 0.83% year over year. However, in that same time frame, net interest income rose from roughly $524 million to nearly $660 million. This is pretty incredible, because it means that even though the bank's assets were earning a lower interest rate (the decline in the benchmark federal funds rate brought down loan rates), SVB still found a ton of loan volume to overpower lower rates and increase net interest income significantly.
This loan activity came about from super-charged venture capital and private equity investment during the pandemic, as investors poured their money into the private markets. The bank also brought in tons of fees from its investment banking division on continued strength in the public markets, while also continuing to capitalize on start-ups' initial public offerings.
Equity warrants
Frequently, SVB will provide services to start-ups that are too risky for more traditional banks to serve. In return for the risk, start-ups will often throw in sweeteners such as equity warrants, which essentially give the bank the right to buy a large sum of shares at a bargain price if the start-up goes public. So big risk, big reward.
SVB has been hitting big on these warrants in the past few quarters, as several of the high-profile start-ups it banks have gone public. In the first quarter, the bank took gains of more than $115 million related to the exercising of warrants it had in the cryptocurrency exchange Coinbase Global. In total, SVB took gains of nearly $222 million related to equity warrants in the quarter, up from just $13.4 million in the first quarter of 2020. This kind of revenue is choppy and hard to predict, but it has become more and more common in recent quarters.
SVB also enjoyed its stellar quarter while taking an $80 million pre-tax charge-off related to one client the bank says may have committed potentially fraudulent behavior. This is one of the few slips the bank has had in credit quality in its venture capital and private equity lending business since the 1990s -- and it didn't stop the bank from producing its best-ever quarter of profitability.
Tons more growth ahead
The knockout quarter and improving outlook have resulted in SVB raising its full-year guidance significantly. The bank now expects average loan balances to increase at a percentage rate in the mid-30s, far above what I've heard any other bank predict for loan growth. Net interest income is expected to increase at a percentage rate in the mid-30s. Average deposit balances are expected to increase at a percentage rate in the high 60s, which is again just incredible considering how much deposit inflows SVB saw in 2020.
SVB is also well-positioned to enter a rising-rate environment when the Federal Reserve starts thinking about hiking the federal funds rate. More than half of the bank's total loan book is associated with the venture capital and private equity lending business, which are tied to shorter-term rates. The bank disclosed in its earnings materials that it will realize $100 million in net interest income for every 0.25% increase in the federal funds rate. With the huge surge in deposits, roughly 66% of the bank's average deposits in the first quarter were non-interest-bearing, which don't cost the bank anything and tend to be more sticky in a rising-rate environment.
The other big news is that earlier this year SVB announced that it plans to acquire Boston Private Financial Holdings, a big wealth-management player. So long as the deal goes through, it could present another huge avenue of growth for SVB. The acquisition not only gives the bank further presence in Boston, one of the world's largest start-up ecosystems, but significantly grows SVB's private banking and wealth management operations. Boston Private comes with $16.3 billion assets under management and $7.2 billion in loans. It also enhances SVB's private bank and wealth management products and technology, and puts the bank in an even better position to cross-sell to its wealthy client base.
SVB President and CEO Greg Becker said the addition of Boston Private enables the bank to grow mortgages, specialty lending opportunities to high-net-worth individuals in the innovation economy, and fee income from wealth management. Overall, SVB has previously called the acquisition a $400 billion opportunity among its current clients.
Continuing to grow
As you can see, while the bank has flourished over the past year, it doesn't look to be even close to tapped out. SVB is very asset-sensitive and well positioned for rising rates; the innovation economy appears to be flourishing with the acceleration of digital trends during the pandemic, and the pending acquisition of Boston Private will allow the bank to further penetrate its existing client base. SVB's investment bank is also projected to have an even bigger year than last year, and the sizable equity warrant gains -- while they may not sustain the kind of activity the bank saw last quarter -- are becoming more and more common.
SVB raised $2.4 billion in debt and equity to continue to support its growth. The bank has grown tangible book value per share by 165% since 2015, which helps grow the stock. Analysts on average are already expecting the bank to generate $27.89 in earnings in 2021. If this kind of earnings power keeps up, or just stays within shouting distance, I think the stock has a lot of runway left.
