Eastern Bankshares (EBC 1.00%), a $22 billion asset bank based in Boston, continues to be one of my favorite mid-cap stocks with excellent fundamentals.
The stock is down more than 18% this year, with the banking sector struggling in general. But that's actually slightly better than the broader market and the SPDR S&P Regional Banking ETF. Bank stocks may continue to struggle in the near term for a couple of reasons: First, interest rates are still rising, and second, the market is factoring in a potential recession next year.
Still, Eastern continues to improve its financial returns and build a franchise that should translate into great long-term value for shareholders. Here's why.
A great franchise
For a smaller bank such as Eastern, investors will really want to focus on its core deposit and lending franchise, both of which are very strong.
The key for any bank's deposit franchise is to have a sticky, low-cost deposit base where the bank has a great relationship with its customers, which prevents them from chasing yield at the first sign of higher interest rates. As interest rates rise, deposit costs are obviously going to go up, but the better deposit franchises will be able to outperform the industry and peers on overall deposit costs.
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Eastern has one of the best deposit franchises in the business,, with 62% of its deposits in checking account products, which are the stickiest and lowest-cost form of deposits. Eastern's deposit costs only increased four basis points, or 0.04% (1 basis point = 0.01%), in the third quarter, despite the Federal Reserve raising its benchmark federal funds rate by 150 basis points. Expect deposit costs to keep rising, but most banks saw a way bigger increase than Eastern in Q3.
Eastern has seen about $900 million of deposit outflows this year but that's because the Fed is unwinding its balance sheet and pulling liquidity out of the economy, which is draining deposits from the banking system. Eastern also brought on $380 million of higher-cost borrowings to its balance sheet in the third quarter, which is not ideal, but this is to fund Eastern's strong loan growth this year.
Speaking of loan growth, Eastern has a premier commercial lending franchise and saw record commercial loan growth in Q3 -- nearly 16% growth on an annualized basis. Credit quality has also been pristine. In 2021, Eastern completed its biggest-ever acquisition, of Century Bancorp, not only giving it the fourth-largest deposit market share in the Greater Boston market, but also strengthening its already strong commercial lending franchise by adding Century's lending expertise in the healthcare and higher education sectors.
Better results despite headwinds
The strength of Eastern's franchise and sensitivity to rising interest rates enabled Eastern to grow its net interest margin (NIM) this year, which is essentially the difference between the weighted yield on its interest-earning assets such as loans and the yield on its interest-bearing deposits such as liabilities.
Eastern's NIM rose from 2.54% heading into the year to 2.87% at the end of Q3. This has also boosted Eastern's return on assets, a good measure of bank profitability, to almost 1%, which is strong for the industry. Eastern's efficiency ratio, which looks at a bank's expenses expressed as a percentage of revenue (so lower is better), also dipped below 60% in Q3 and is heading in the right direction.
While helpful to NIM, rising interest rates have also served as a headwind because they have crushed bank bond portfolios. Bond values and bond yields have an inverse ratio, so rising bond yields lead to falling bond values. These paper losses have eroded bank tangible book values, or their net worth, which banks also trade relative to.
Data by YCharts.
However, keep in mind that these are just unrealized losses and if Eastern is able to hold its bonds long enough, there's a big probability it will recoup the losses as interest rates slow and bond portfolios recover. The only way Eastern could get in trouble is if it had to sell bonds while they trade at a loss, but the bank has plenty of liquidity, so I don't see this as a concern.
A great outlook
While rising interest rates could continue to be a headwind for the banking sector, I think they will also ultimately show just how valuable Eastern's low-cost deposit base is.
In an early outlook for the year, management is guiding for commercial loan growth to around mid single-digit percentage growth, which should significantly outpace gross domestic product growth next year.
Management also expects NIM to move into the low 3.0%s by early 2023, which implies continued solid growth as well. This is also happening as management is guiding for expense growth of 9% to 10% next year. This is certainly no small increase, as management invests in technology and deals with higher salaries, but analysts on average still expect strong earnings growth in 2023.
Ultimately, banks may be challenged in the near term, but Eastern continues to boost its returns and position the bank for long-term success.
