Since going public at the end of 2020, Eastern Bankshares (EBC 0.38%), a roughly $22-billion-asset bank in Boston, has performed extremely well, with shares up nearly 67%. While a quick glance would suggest that the company is trading at a very high valuation for a bank right now, I would argue that Eastern really has a much more reasonable valuation than meets the eye. The bank will also benefit immensely from rising interest rates, which is why investors should take a look at this stock.
Why Eastern's valuation is artificially high
Not long after going public, Eastern announced its plan to acquire its peer Century Bancorp. Banks trade relative to their tangible book value (TBV), or net worth. The acquisition of Century diluted Eastern's TBV by 9%, which will be earned back over four years.
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Furthermore, Century is a bank that had a large securities portfolio. Eastern's total securities book ballooned from roughly $4.85 billion in June of 2021 to now more than $8 billion.
As interest rates have risen aggressively, banks' bond portfolios have taken a hit -- rising rates push down the value of bonds, resulting in unrealized losses, which banks must report each quarter. These unrealized losses or gains are classified under accumulated other comprehensive income (AOCI). AOCI at Eastern totaled more than $661 million at the end of Q2, and it is subtracted from shareholder equity or book value. Eastern's TBV per share has declined from $16.33 at the end of last September to $11.52 at the end of the second quarter, largely because of dilution from the Century deal and the hit in the bond portfolio.
Eastern's stock price, however, has held up relatively well and is up roughly 10.8% over the last year. Trading around $20 per share, Eastern trades at 174% of its TBV, which is somewhat expensive for a bank right now. If Eastern's book value per share were $16.33, the stock would trade at 122% of TBV per share, so investors might understand what's going on here.
Benefitting from higher interest rates
As a big commercial lender with a superb deposit base, Eastern also stands to benefit from the rising-rate environment, which already started to play out in the second quarter.
Eastern grew net interest income, the profit banks make on loans, securities, and cash after funding those assets, by nearly 8% from the first quarter. The bank's net interest margin, which essentially shows the spread between what the bank pays on interest-bearing liabilities such as deposits and what it earns on interest-earning assets such as loans, expanded by a whopping 21 basis points (0.21%) in the quarter to 2.63%.
That's because Eastern has a very sticky deposit base that is not as sensitive to rising interest rates. For instance, in the second quarter of the year, the Federal Reserve hiked interest rates by 135 basis points (1.35%) and Eastern's deposit costs actually declined by one basis point in the quarter. Now, there is a lag on deposit costs, but most banks saw at least some movement in the quarter, given the aggressive nature of the Fed. Eastern's management team acknowledged it expects deposit pricing to start moving higher in the current quarter, but make no mistake -- Eastern has a very high-quality deposit base.
As a large commercial lender, Eastern also has a lot of variable-rate loans that will see their yields re-price quickly with interest rates. Eastern disclosed that 39% of its loans at the end of Q2 will re-price within one month. This, coupled with its strong deposit base, should continue to enable margin expansion. Management also raised its guidance for net interest income for the full year to come in between $570 million and $590 million, $40 million higher than prior guidance.
How to think about valuation
The dilution from the Century deal is going to take Eastern about four years to earn back, but does help create a franchise with more scale, so the move should pay off. In the near term, Eastern should also see TBV per share increase as bonds mature and as higher profits come in due to higher interest rates.
That's why, even though the bank trades at a fairly high valuation of 174% to TBV right now, I think this is artificially high. Eastern's valuation is likely more attractive than what you see on paper.
I think Eastern is a top-tier bank given its strong deposit base and commercial lending franchise. I do ultimately think it will continue to grow TBV and achieve a strong valuation and good returns for shareholders.
