New York Community Bancorp (NYSE:NYCB), a $47.6 billion bank headquartered in Westbury, N.Y., will release second-quarter earnings results on Wednesday. Let's take a few minutes to review the bank's operations in preparation for the new numbers.
You can find information on other banks at my Motley Fool article feed, available here. All data in this analysis was sourced from the FDIC's Quarterly Banking Profile and S&P Capital IQ.
When I evaluate banks, I follow a model made famous by former Wachovia CEO John Medlin: soundness, profitability, and growth. As investors, we then look at valuation and the potential for investment after gaining a better understanding for each bank.
Soundness refers to the bank's asset quality. Generally speaking, this means loans. If a bank makes loans that are never repaid, that institution will quickly fail. The best banks put risk management first, ensuring that shareholder capital is protected if a portfolio of loans turns sour.
To measure this at New York Community Bancorp, we'll consider both nonperforming assets and the bank's provision for loan and lease losses. Put simply, nonperforming assets are loans or other assets that have fallen seriously delinquent or are in foreclosure.
The provision for loan and lease losses is a reserve of money that the bank pulls out of its income each quarter to guard against future losses in the loan portfolio. Banks are required to maintain certain levels of reserves, but within that management has plenty of wiggle room to set the reserve level. Over-reserving increases protection but hurts net income; under-reserving increases risk but keeps net income high.
For the quarter ended on March 31, New York Community Bancorp had 0.9% in nonperforming assets as a percentage of total assets. The FDIC reports that banks with total assets greater than $10 billion on average had 1.5% in nonperforming assets as a percentage of total assets.
New York Community Bancorp actually released $14.6 million from its loan loss reserves for the first quarter, which represented just shy of 5% of the bank's operating revenue. This compares with a 5% reserve addition for the $10 billion+ peer group, according to the FDIC.
The relationship between a bank's reserves and its NPAs helps us understand management's view on the direction of the bank's loan portfolio. Over the past four years, New York Community Bancorp's nonperforming assets have steadily declined, while at the same time the bank's loan loss reserve has steadily grown.
That is, until the fourth quarter of last year. The loan loss allowance declined by about $5 million in that quarter, followed by the near-$14 million reduction. This suggests that the bank's loan portfolio, while already better than industry averages, is poised for further improvements.
Next we can focus on profitability. Any investment in a business is an investment in that company's future earnings, so profitability is a particularly important consideration for any bank investor.
The first question, perhaps most obviously, is whether the bank actually generates a profit at all. According to FDIC data, 7.3% of U.S. banks failed to generate a profit at all in the first quarter. That's one in every 14 banks!
New York Community Bancorp generated total net revenue of $321.3 million in the first calendar quarter of 2014 -- that is, total interest income plus noninterest income minus interest expense.
Over the past 12 months, New York Community Bancorp generated $1.3 billion in total net revenue. Eighty-eight percent of that revenue was attributable to net interest income, the difference between interest earned on loans and that paid out to depositors. The remaining 12% was through fees, trading, or other noninterest revenue sources.
The bank turned a profit margin of 35% on that revenue.
For the first quarter, the company reported return on equity of 8%. Of the banks covered in this series of articles, the average return on equity was 8.9%. The FDIC reports that the average ROE for U.S. banks with total assets greater than $10 billion was 9.1%.
For bank investors, this profile is about as good as it gets. The bank is simplistic, with the vast majority of its income coming from interest on loans. It's a tightly run operation, producing a profit margin 50% better than the industry average.
Leverage is a double-edged sword for banks and could easily fit into either the soundness or profitability categories. We'll call it a subset of both and discuss it here.
Leverage is just part of the game with banks, so if you're a conservative investor who focuses on conservative capital structures, the banking industry may not be the best place for your money. Adding leverage is an easy way to juice return on equity, which is generally speaking a good thing. The bank increases assets and thus earnings, while maintaining a lower capital level.
The result is a higher numerator, a constant denominator, and a larger return on equity number. The math does the heavy lifting for you.
On the flip side, too much leverage can put a bank on thin ice if the loan portfolio takes a turn for the worse. A stronger equity base protects the bank from bankruptcy and bailouts, two outcomes that are both politically charged and downright terrible for shareholders.
Banks use all kinds of esoteric and overly complex accounting methods to determine leverage. We'll keep it simple here with an old-fashioned assets-to-equity ratio. The lower the number, the less levered (and more conservative) the bank.
New York Community Bancorp's assets to equity ratio comes in at 8.3 times. The average of the 62 banks analyzed in this series of articles was 9.1 times. The bank's below-average return on equity, mentioned above, is primarily driven by the conservative capital structure we see here.
Growth and valuation
New York Community Bancorp saw its revenue decline about 4% over the past 12 months. That compares with the average 5.7% increase among the 62 banks analyzed.
This change in revenue corresponded with a 5.9% decline in net income over the same period. The peer set averaged a 14.1% gain. Fifty-four percent of all U.S. banks saw year-over-year earnings growth in the first quarter.
The declines in both revenue and net income were mitigated by an sizable increase in the bank's total assets.
On valuation, New York Community Bancorp traded at a forward price-to-earnings ratio of 15 times, according to data from S&P Capital IQ. This compares to the peer-set average of 16.7 times.
New York Community Bancorp's market cap was, at the time of this writing, 2.1 times its tangible book value. The peer set average was 1.9 times.
Many investors use a general rule of thumb of buying a bank stock when the price-to-tangible book value is less than 0.5 times and selling when it rises above two times. For me, that method is far too oversimplified.
It sometimes makes sense to pay a premium for a bank stock that places a high value on credit culture and asset quality. These banks will survive and prosper while others fall by the wayside. That security can be worth a premium. Likewise, a bank that relies heavily on leverage to achieve an above-average return on equity may not be worth the price, even if price-to0tangible book value is low. That risk may not justify even a healthy discount in price.
Based on the factors discussed in this article -- soundness, profitability, and growth -- New York Community Bancorp appears to be undervalued. While priced slightly above the peer-set average on price-to-tangible book value, the bank is built on a rock-solid balance sheet with a healthy loan portfolio and conservative leverage. The bank's profitability metrics are among the best in the industry, and the growth in total assets position the bank well for a rising rate environment over the next five years.