Can People's United Get Ahead Of The Curve?

By Stephen D. Simpson, CFA | January 14, 2013 AAA

It can be frustrating for investors to own high-quality, low-risk assets in a "risk-on" environment, and that certainly seems to be true of late in banking. While investors in riskier names such as Bank of America (NYSE:BAC), Synovus (NYSE:SNV) and Regions Financial (NYSE:RF) saw sizable gains in the stocks, investors in the more conservatively run People's United Financial (Nasdaq:PBCT) had a significantly different 2012 experience. Given that this company is unlikely to find ways to deploy substantial amounts of capital in 2013, the sluggish yield curve could point to another tough year for investors.

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Conservatively Run and Full of Capital
People's United is hardly a bank run by gunslingers. Non-performing assets have consistently been less than 2% of assets for quite some time, and this bank sticks with relatively inexpensive low-volatility sources of funds.

At the same time, the company has actively looked to increase its lending balance towards commercial lending - despite the commonly held view that commercial lending is riskier, properly underwritten commercial lending actually offers superior risk-adjusted returns.

As part of its conservative outlook, People's United holds very high levels of capital. The most recent tangible common equity (TCE) ratio for the bank was about 11.2%, whereas most of its similarly sized comparables in the region (the northeast) had TCE ratios in the mid-8% range. While excess capital may sound like a good thing coming out of a banking crisis in which many banks were starving for capital, excess capital essentially represents unused potential earnings power - meaning that, to some extent, PBCT investors are trading growth for security.

Capital Deployment May Be Challenging in 2013
Even if People's United wants to bring down its TCE ratio substantially, there aren't a lot of options for doing so over the near term. The company already pays a very generous dividend and engages in share buybacks. Accelerating buybacks could also have the adverse consequence of making the stock less liquid and less attractive to large institutional owners.

That leaves acquisition and business expansion. Business expansion may be logical in markets such as New York and Massachusetts, where the company has low single-digit share, but building more branches doesn't really promise growth unless the bank is willing to pay more for deposits or charge less for loans. Getting into a price war with larger banks such as Bank of America, Citigroup (NYSE:C) or Toronto-Dominion (NYSE:TD) would not only be a very "un-People's United" move, but would likely be not all that beneficial to long-term growth either.

On the acquisition side, the company has been plenty busy over the past four years, including a relatively recent deal for 57 branches from the Royal Bank of Scotland's (NYSE: RBS) Citizen's Financial. While there are other small banking franchises in the People's United target area, valuations have definitely expanded over the past year. What's more, while building up the company's fee-based business (roughly three-quarters of the company's pre-provision revenue is from interest) would be a good use of capital, there aren't an abundance of attractive assets available for sale (at least not at good prices).

A Slow-Burning Match
The good news for People's United shareholders is that this continues to look like a business that will reward patient shareholders. The company has a strong franchise in Connecticut and Vermont, and has broken into the top 10 of deposit share in Massachusetts after being No.16 about two years ago. Along those lines, targeting affluent counties/areas in New York is likely to fit right into the company's strategy of high-quality, focused growth.

Still, this is going to take time. While the company's target of an efficiency ratio of 55% in 2014 is appealing (against 61.4% in the third quarter of 2012), the reality is that the current flat yield curve is going to put a lot of pressure on the company's net interest margin. People's United doesn't have the same capability as Citigroup or U.S. Bancorp (NYSE:USB) in offsetting NIM pressure with fee-based income growth.

The Bottom Line
The high capital ratio at People's United earns it a lower cost of equity in my returns on capital model than I would normally apply for a bank this size. Unfortunately, the low return on equity here counterbalances that to a large degree. Even if the company can lift its return on equity to the mid 8% range (against a long-term average of about 2.80%), the stock is no better than fairly valued today. In fact, it takes a return on equity of about 10% to really start driving an appealing fair value.

The good news is that People's United pays a very appealing dividend at present (a yield of over 5% as of this writing). Moreover, I do believe the bank has the potential to produce a 10%-plus return on equity down the line, though that is by no means a sure thing. Accordingly, this looks like an interesting conservative bank option for investors content to collect dividends, but investors seeking more dynamic growth potential may be frustrated with this company's operating philosophy.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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