Paying a consistent dividend requires a solid financial foundation -- a company must have plenty of both capital and profits. I've uncovered one stock that has both, making its dividend ripe for an increase.
That stock is First Republic Bank (NYSE:FRC), a regional bank that specializes in making loans to the richest 1% of Americans. The bank's dividend currently yields a respectable 1.2%, but it could rise sharply in the future.
A rock-solid financial foundation
Last week, First Republic reported calendar-year and fourth-quarter results for 2014. The numbers are quite impressive.
Quarterly on a year-over-year basis, revenue increased by 17% and core net income reached a company record $453 million, both driven by the bank's second-highest volume of loan originations ever.
The bank was a subsidiary of Bank of America (NYSE:BAC) until being spun off in 2011 by management and a group of private equity firms. Since that time, the bank has flourished, as illustrated by the net income and revenue lines in the chart below.
Along with strong results on the income statement, First Republic has a rock-solid balance sheet. Having that strong capital base makes the dividend that much stronger, because the bank has adequate capital to sustain the payout even if profits hit a short-term hiccup.
First Republic will likely pass the critical threshold of $50 billion in total assets in 2015, which brings much more stringent regulatory requirements, including annual stress testing and regulatory approval of capital allocation decisions. In other words, if federal regulators don't think the bank has adequate capital, they can shut down the dividend. I don't see this as being a problem for First Republic, though.
The company's assets-to-equity ratio as of Dec. 31, 2014, was an acceptable 10.1 times, which is more or less typical for a bank of this size. For context, many banks in the pre-financial crisis era had asset-to-equity ratios of 25 times or more.
From the regulatory perspective, First Republic reported a tier one leverage ratio of 9.43% as of December 30, 2014, well above standards to be considered "well-capitalized" by regulators.
Challenges that could derail future profitability and growth at First Republic
In the banking industry, analysts use a metric called the efficiency ratio to measure how well a bank controls its expenses. A lower ratio is considered more efficient.
Over the past several quarters, First Republic's efficiency ratio has been slowly creeping higher. While that is certainly cause for concern, there is justification for the increase in expenses.
Management said on the fourth-quarter conference call that the bank should hit that $50 billion in total assets in the second or third quarter of 2015. When that happens, the bank must be prepared to deal with the assortment of new regulatory requirements, audits, rules, and procedures. That increased regulatory burden has a very real cost, and we can see that expense in the bank's rising efficiency ratio over the past year or two. Those costs include added personnel in the risk management department, more robust technology solutions in enterprise risk management and forward modelling, as well as the cost of existing management devoting time to audits and regulators instead of growing the franchise..
However, once the bank grows past $50 billion, that regulatory expense should level off in absolute terms. That means the bank can continue to grow and continue to increase profits, but keep those expenses at today's level. When that happens, the efficiency ratio should decline toward the longer-term average.
The bank's efficiency ratio for 2014 was 57.6%, which was about 5% higher than the numbers First Republic reported in 2011 and 2012.
A great company for the long term
The thing about First Republic Bank is that it's so much more than a dividend stock.
The company's revenue and profit are growing like weeds. It serves a highly affluent client base that represents some of the highest credit quality loans available. Management is strong and has been with the bank since it was founded over 25 years ago.
The stock currently trades at 1.7 times book value. While that isn't a bargain-basement price, I think it's a very fair value for one of the strongest bank stocks available today.