Not Quite a Bailout: So Much Banking News to Discuss

In this podcast, Motley Fool senior analyst Jason Moser discusses:

• Signature Bank failing and shares of First Republic Bank falling.
• Why "bailout" is probably not the right word to describe what's happening.
• How big banks like JPMorgan Chase and Bank of America are gaining strength simply by going about their business.

And we've got Motley Fool analysts facing off, bracket-style, as they go head-to-head over which stock is a better buy. Jim Gillies and Jim Mueller kick off the week with a biotech software company and a well-known real estate broker.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on March 13, 2023.

Chris Hill: We're kicking off our own version of March Madness. Motley Fool Money starts now. I'm Chris Hill, joining me today, Motley Fool senior analyst Jason Moser. Thanks for being here.

Jason Moser: Hey, thanks for having me.

Chris Hill: So I said this on Friday show, the situation is fluid. It continues to be that way and for anyone who missed it on Friday, you, me, and Matt Argersinger talked about Silicon Valley Bank. The possibility that by Sunday night, Silicon Valley Bank could by then be the property of another bank. That is not the case. What is the case is that Signature Bank, which is a commercial bank based in New York, has also been seized by regulators. Shares of First Republic Bank, which is based in California, are down 60%, as you and I are chatting on Monday afternoon, and at one point today shares of Charles Schwab. Just plugging along. I don't want to use the word boring, but I can't think of another, just boring ol' -- I like Charles Schwab, but at one point, Charles Schwab was down 20%.

Jason Moser: My single retirement plans are through Charles Schwab. 

Chris Hill: Right. This cut me wondering like, wait, what's happening at Charles Schwab that has this. There's a lot going on here. Where do you want to start?

Jason Moser: I think this is all just a really good reminder of the psychology that is in play when something like this happens, when you talk about Silicon Valley Bank, in simplest terms, this was a failure of bank leadership that ultimately resulted in a bank run. The bank put itself in a precarious position with its investments. Clients started withdrawing funds at a more precipitous rate. Word got out, there might be some capital issues and it just feeds on itself. Regulators had no choice but really to get in there to shut it down. There are a lot of questions over the weekend. One of the big questions was, is this something indicative of something more systemic throughout the entire banking system? I think most of us felt like it probably was not.

I think the main reason was just because of the nature of Silicon Valley Bank and the clients that it serves. Its clients are generally companies that that keep very large balances. Balances well beyond the $250,000 FDIC insurance limit. Further, these are companies where they're not only keeping part of their balance sheets, but they're also running their day-to-day operations to keep the business running, which includes payroll. You don't see companies meeting the payroll then employees don't get paid and now you start to see the second- and third-order impacts from a problem like this. I think it made a lot of sense for regulators to view this as an urgent situation. It sounded like they were trying to go a few different ways with a solution there. It is very interesting to see that they didn't really have any bidders.

They had to get creative with a solution. I think ultimately the solution is a good one. It's going to be politicized and you're going to have fundamentalists from both sides of the aisle arguing their cases. Granted, I think that's more philosophical and theoretical in nature. This is the real world. We had to come up with real-world solutions. Longer-term consequences be damned. We can deal with those another time, but like they say it, patient's bleeding out, you've only got so much time in solving the problem, the help, if you let the patient bleed out first. They really they stopped the bleeding and I think it makes a lot of sense. I think it's important to remember like you're going to hear the phrase bailout bandied about, I think a good bit with this and I would be careful using that term. I think that this is not something that bails out shareholders. This is not something that bails out executives.

Their fate is sealed. This is something that is protecting depositors who really, at the end of the day, were just looking for a place to put their money to run their businesses. I think it's going to be interesting to see how this shapes that deposit landscape going forward and how we view banks and our financial system here in the United States. It does feel like banking has really become a utility and I don't know that we should blame folks for just wanting to deposit their money. It does feel like we will see a shift in how that risk is perceived going forward and these new facilities that the regulators are developing to protect not only the institutions but the depositors as well. A lot going on for sure, still plenty I'm sure to unfold, but it does look like they got ahead of this to prevent what could have been a wider-spread contagion.

Chris Hill: To be clear, the money that's being used to reimburse the depositors would come from a fund that has already been established that is paid into by U.S. banks. I don't want to speak for anyone else, but when I hear the term bailout in the past, one of the places my brain automatically goes is like, this is going to be taxpayer money. They're going to write a check from the federal government and it's going to be taxpayer money. It'll be additive to that thing. This is not that situation, so to your point about let's be careful with using that word. I think [laughs] that's well-taken.

Jason Moser: Yeah.

Chris Hill: As I said on Friday, somewhere on the spectrum of outcomes for Silicon Valley Bank was a larger bank steps in and buys them. I suppose technically that's still a possibility. Although the big banks have been very quiet for the most part and I'm wondering, since this is an industry that you and Matt Frankel used to talk about every week on the Industry Focus podcast, what you see when you look at the big banks right now, because one of the things I'm wondering is, are the big banks, simply by virtue of sitting quiet, are they strengthening their position? Are they just very quietly making it obvious. Hey, you know what, you're not going to have a problem with if you bank with JPMorgan Chase or Bank of America, you're not going to have this problem.

Jason Moser: Yeah. It's a very fair question. That would be a criticism I think a lot of folks would have in regard to what's going on in regard to the solution is that ultimately it makes the rich richer and makes the strong stronger and there certainly is something to that, we saw over the weekend the news in regard to First Republic Bank out there in California, $15 billion bank, well-capitalized regional bank. They even felt the need to get out in front of this and notify their account holders and shareholders that they were well capitalized. This was something that was not impacting them, the technology-related deposits represent only 4% of their total deposits and yet even that didn't do it right. We saw lines over the weekend of folks wanting to get their money out of First Republic, and that in turn led them to then shore up capital from not only the Fed, but from one of the big banks, JPMorgan, that helped infuse some capital into First Republic, more or less, to just make sure.

That communicates a message where on the one hand, First Republic is putting out an 8-K saying, hey, don't worry about us, we're fine. Then at the same time they're raising money just, just to make sure. It does create a conflicting message which makes you wonder. I think that's going to be something going forward. I think that is one of the reasons why figuring out a longer-term reasonable solution to this makes so much sense because at the end of the day, if we're to a point where deposits, you can't really be blamed for wanting to deposit your money. Deposits, that's now more or less just a utility, you're not going to just keep your money in a coffee can and under your bed or buried in your backyard. You've got to deposit your money somewhere and for many of these businesses, you want to split up to $250,000 among however many banks. It becomes not very practical. I think at the end of the day, this will give the banks small, medium, and large an opportunity to participate on at least somewhat of a level playing field because those deposits will essentially be protected.

Now it does. We have to see ultimately how this facility works out. I mean, we saw that the regulators produced this facility. Going forward, banks who run into this situation where they see a run and they need to shore up some capital to make sure, even if it's through no fault of their own, they have the opportunity to participate in this lending facility to keep their finance assured. It remains to be seen whether that ultimately works or not. But in theory that should help keep these banks a little bit more level playing field as far as depositors are concerned and that will be good. But right now, it certainly does make it look like, the rich get richer and the strong do get stronger. That's not a surprise. Banking is certainly not the only industry that deals with that type of dynamic. But again, I have a feeling we're going to be talking about this I think for the rest of the year. 

Chris Hill: I was just about to say that. I was also going to add, I have a feeling by the end of the week, we're going to hear from Jamie Dimon.

Jason Moser: Yeah, absolutely. I mean, anytime Jamie talks people listen.

Chris Hill: Jason Moser, thanks so much for being here.

Jason Moser: Thank you.

Chris Hill: March Madness starts this week. Even if you're not a fan of college basketball, don't worry, we've got our own tournament with eight analysts facing off against each other, pitching a stock that they believe is a better buy than the other analysts' stock. Today in the first of our quarter-final matchups, Ricky Mulvey referees a debate between Jim Gillies and Jim Mueller. Which stock is a better buy: a biotech software company or a well-known real estate broker? This segment was recorded during The Morning Show on The Motley Fool's live video stream, which is available to members of any Motley Fool service. 

Ricky Mulvey: Kicking off the first round of March Madness, the Motley Fool Money World Champion Stock Competition. Jim Mueller, 5-6 minutes is yours, I'm going to go on mute and listen in.

Jim Mueller: The company I'm going to pick is one I own myself and one that is an active Options recommendation. It is Schrödinger, it's on the Nasdaq under ticker SDGR. You might think of it as appropriate given my biochem background, but I've never, ever recommended and have not invested in biotech for years. It is a biotech company but not your general run-of-the-mill biotech company, no, if they didn't do biotech, they'd actually be profitable and cash-flow-positive. It started off as a software company, so it has four ways to make money. Software sales being the first one. It's a software company that has developed a way to predict how molecules interact with each other down at the molecule-to-molecules scale using physics and a whole bunch of X-ray crystallography and NMR imaging that have been developed over the years. What they're doing is being able to use a computer and an algorithm or an AI to predict how the molecules interact and therefore finding the best molecules that could act as a drug against the particular target.

What you want with a good drug is you want high specificity, that is, the drug molecule will bind only to its target and not to anything else, so fewer side effects. You want a strong binding and so they use this algorithm, their software to find candidates that will do that. What this does for drug discovery companies, is cut down several years out of the decadelong process of finding a drug, but it's all at the front end, the discovery phase. Instead of screening in a laboratory, hundreds of molecules, they can screen on computer thousands of molecules to find the best one and they build it in. Then they go through the process of making sure it works the way they think it does. Starting up the clinical trials, then phase 1, phase 2, phase 3 trials, and so forth. That long part of actually trying out the drug first in the lab and then with actual humans hasn't changed, but it's the front end and that's a fairly expensive portion of the drug discovery process that companies are willing to pay to shorten.

That's how Schrödinger got its start. They had a couple of successes early on. It got a couple of drugs all the way through FDA approval with one of the partners, Agios. They've since collaborated with many of their customers. They sell the software, they've collaborated with many of their customers, and currently they have nine different drugs in their collaboration program in clinical trials. Three of which are in phase 2, the other six are in phase 1. We're in the slow part of that portion. That's the second way they make money. As those drugs meets certain milestones such as getting into being approved by the FDA or passing phase 1 or passing phase 2, they get paid. Last year, they got paid about $45 million from those milestones, this year, they expect double that. Their third way of getting paid money is by buying, and actually investing in some of their partners. As that company becomes more valuable with a successful drug, they get their portion of that value. That's their third way. The fourth way is the prize itself.

Finding their own drugs and being able to get them through this process and start selling them to the market or licensing out to a big pharmaceutical. They have several of their own drugs now, just entering clinical trials, they've got one in phase 1, and they have identified another that they've just identified last quarter and they're putting it together, getting data ready to apply to the FDA to be allowed to do the phase 1 trials. Drug discovery is very expensive and most of the time companies like this get invested in by other companies and they can get money from that and they sell debt and all this other stuff, Schrödinger is funding itself from its own software sales and from the drug milestone payments that it receives. They burned about $112 million off their cash balance last year.

At that rate, they have about four and a half years' worth of cash on the balance sheet, but this year they're expecting to get about 90 million instead of 45 million, about 90 million in drug discovery milestone revenue. That increases the length of term. If all else remains the same, they're only going to burn about 80 million instead of 112 million off their cash and so they're extending their lifetime as a cash-burning company at this point. It's a bet on the future, a bet on software being able to lead to better molecules that lead to better drugs and getting them through the FDA process. It's a long-term bet on that and so the share price, I think is attractive at this point. It was as high as 110 shortly after they became public in February 2020, it's since fallen down into the mid-'20s. It was down as low as the teens at the end of last year, but it's recovered quite a bit since then.

Ricky Mulvey: Five to six minutes on a high-level software company without talking about artificial intelligence.

Jim Mueller: I mentioned it. I said AI. But AI is just computer software algorithms working together, that's all it is when you come right down to it.

Ricky Mulvey: Yeah, that's not as fun. Jim Gillies is coming with his stock, 5-6 minutes is yours.

Jim Gillies: Sure. I am coming at it from almost pretty much the opposite end of the market as my esteemed colleague is. He's coming for high tech and brainiac performance. I'm going to look at companies that are, well, some of the things I like to say are run toward fires, which is a variation of say, contrarian thinking, I want to run toward fires. I went by businesses that are on on fire. My take on it is because we want to do, this as a long-term contest. We're not just fighting over March Madness. We're looking for stocks outperforming for the long term. For that perspective, I hold the view that your best long-term performers come from low prices paid during pessimistic times either for the market itself or for the stock itself. This is a company that has a pessimistic market and that company is not as cool and sex as Schrödinger, it just makes money, which is different than Schrödinger as well.

It is RE/MAX, the real estate people. RE/MAX is a franchisor of real estate and mortgage brokerages. They have about 143, 144,000 agents under them. Roughly 60% in North America, the rest international. What's interesting about RE/MAX is it is not a traditional business. They like to sell franchises and I like franchise businesses because I sell someone else a concept, I get a royalty from them, they get the operational risk. What is not to like. I call them check-cashing machines. I sell you my concept and branding operational know-how systems, franchisee sends a percentage of their gross revenue back to me as royalties in addition to paying regular franchise and regular marketing fees. That means RE/MAX gets to hold onto a high-margin growing revenue stream for them to deploy. One of the interesting things about RE/MAX, and I'm going to share my screen in the middle of this if that's OK.

This is a history of RE/MAX as transactions per agent at their largest brokerages. You can see they're typically in the 16-17-plus transactions per year per agent. These large brokerages compare to a number that goes between seven and eight for their competitors. This has been a long, long-standing trend. Why is that? There's something different happening when your average competitor, their average agent's doing about seven-and-a-half times transactions a year and you're doing 10 more than that, what's going on? This is the secret sauce for RE/MAX. It's how the commissions are split. Traditional brokerage, the broker takes 20%-30% of the commission. When you pay a fee to sell your house, one-third of that say goes the brokerage, two-thirds stays with the agent, and then of course they have to split it with the other agents and whatever. RE/MAX has a more agent-favorable mix.

The agent keeps 95% of the commission and RE/MAX the brokerage takes 5%. That leads to a phenomenon where the best agents, people really good at selling, they migrate to RE/MAX banners because I'm betting on myself, I get to keep more of my money. That's a very powerful incentive. I get to keep more of the money. I go out and shoot and kill and bring it home. I get to keep more, that's fantastic. The way that RE/MAX at the company offsets that more favorable mix to the commissions setting up their people who are causing their money to do better, the way they do that is there's annual dues paid per agent by the brokerage. There's a fixed fees per agent. There's our broker fees, which is about 5% of take, franchise sales and monthly fees for their mortgage office. Look, there's no tag days for RE/MAX, but there's not-easy-to-replicate secret sauce that brings the best agents under their banner. Why did I say an industry on fire? Well, a year ago, real estate was great.

We don't build enough houses. Homebuilders are going to the moon. Then central banks said, hey, interest rates are too low, started jamming them straight up, and that has quashed house prices, it's quashed sales. The entire real estate market has washed out, anyone who's a Redfin owner could attest to that, or Zillow owner. I'm looking for a company in the space that's blown out. I'm getting cat calls from Mueller here. I'm looking for companies in the space that are going to do better on a cash-flow basis because they can weather the problem. Here's RE/MAX today. Hopefully, you bought into what I've said here, RE/MAX today, it's pretty much at its lowest share price of all time since its 2013 IPO. Aside from the downdraft in the pandemic, which was weird for everyone. But what do we have in RE/MAX today? We have a company, and by the way, the founders still own 40% of the dual share class structure. They own 40%.

The two members, that's the husband and wife team, the husband's CEO for years took zero in compensation because he just got dividends. Same deal with the wife, they're both on the board today, took zero compensation. Something about Foolish founders. I don't know, you can insert it here. But the company today, if you adjust for the outside ownership or the 40% ownership by the insiders, you have an enterprise value of about $890 million. That is, they have about 448 million debt, 109 million cash, and an enterprise value, like I said, 890 million. That is about, I estimate this company can do about $70 [million] to $75 million a year in free cash flow. That means the stock is trading at about 12, 12.5 times free cash flow. That free cash flow number is going to be going up over time as they sell more franchises and more Motto Mortgage franchisers, should say the Motto Mortgage brokerage, which is a nascent thing within them.

But 230 outlets going to go to 1,000 over the next decade. That is currently a cash suck. It's going to be a cash contributor in the future. But I say for 12 times cash flow in a depressed industry, I'm willing to do this all day long with a recognizable brand because here's the thing. We know Schrödinger and I don't mean to pick on Schrödinger, but Schrödinger has got a great deal of uncertainty of what drugs are going to work. That's the whole schtick of biotech. What is going to work. I'm not smart enough to figure that out. But here's what I do know. I do know people are going to be selling more and more houses. People need to move. There'll be household formations. I'm going to bet on a much, much more sure thing, and at a pretty reasonable price. By the way, you get a 5% dividend yield to wait. With that long-windedly, I yield my time. 

Ricky Mulvey: Jim Gillies, thank you. Jim Mueller, thank you. 

Chris Hill: We'll reveal the winter next week during the semifinals again, that was recorded during The Morning Show on Motley Fool Live, which if you're a member of any Motley Fool service you can watch on tomorrow's show. Tim Beyers goes up against Sanmeet Deo.

As always, people on the program may have interest in the stocks they talk about. The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.