First Republic Looks To Be A Very Different Kind Of Bank

By Stephen D. Simpson, CFA | January 11, 2013 AAA

Costs have become something of a grand obsession with commercial banks recently, as regulatory changes have cut off formerly lucrative revenue sources. First Republic (NYSE:FRC) is a different sort of bank, though. This bank focuses on growing its share of the lucrative high net worth (HNW) market, and it's using a "high-touch" model that has thus far generated solid high-quality growth.

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Hunting the Elephants and Whales
Whereas other California banks like Wells Fargo (NYSE:WFC) and City National (NYSE:CYN) generally try to get as many depositors as they can with a minimum of expense, First Republic has targeted HNW individuals as its clientele. This has enabled the company to become the No.10 bank in California (by deposit share) and the No.26 bank in New York with only 56 deposit-taking branches in eight cities.

Importantly, First Republic focuses on building long-term relationships that deliver value to those customers. Whereas most banks struggle to sell more than two or three services to depositors (and Wells Fargo stands out with nearly six products per customer), First Republic averages about nine per customer. Better still, this clientele has served the company well in terms of credit quality - since 1985, the bank's cumulative loss on originations is just 0.06%.

Analysts estimate that First Republic has between 4% and 5% share of its targeted HNW market. While the company will continue to look to build share on the basis of strong word of mouth and execution, it is also building up its non-interest service offerings like asset management. To that end, the company announced in November that it was acquiring Luminous Capital, an asset/investment advisory firm targeting HNW customers.

Rates Are Still a Risk
While First Republic focuses on long-term relationships, in reality the short-term environment is not terribly helpful. The company's non-GAAP net interest margin was roughly 3.5% in the last quarter, but new loans are yielding an average of 3.2%. What's more, while the company has brought its cost of deposits down significantly since last year (0.22% in Q3 2012 versus 0.40% in Q3 2011), a 0.22% cost of deposits allows little room for further reductions.

That's not to say that the company cannot continue to grow, though. For starters, the low-rate environment does seem to be helping to drive traffic to the bank, and loans were up more than 7% in the last quarter. As a large percentage of the company's lending base is hybrid ARMs, the company can arguably afford to give up a little bit of pricing today for the sake of the long-term relationship. Moreover, cross-selling those customers other services like asset management creates an opportunity to recoup lost interest margin.

Investors should also note some risk to the company's security portfolio. First Republic earns an uncommonly high return on its portfolio (in excess of 5%) because it invests heavily in municipal bonds. Reinvestment risk is a concern, however, and if the municipal credit market has a bad 2013, First Republic will pay a price.

The Bottom Line
While many banks - including Bank of America (NYSE:BAC) (from which First Republic bought its independence back in 2010), Wells Fargo and U.S. Bancorp (NYSE:USB), are looking to build up their HNW business - I believe First Republic is uncommonly well-suited to grow its presence in this market. While these larger banks try to deliver a higher level of service to HNW customers, First Republic's entire corporate culture is permeated with that focus on customer service. Accordingly, I believe the company has an above-average chance of successfully delivering strong loan and profit growth over the next 10 years.

The downside to these shares is that the Street is already more or less on board with the company's above-average prospects. An excess returns model predicated on long-term return on equity of 13% doesn't suggest much undervaluation today, nor does an analysis of book value and owner earnings growth over the next decade. Were these shares to pull back closer to $30, I would be much more interested. But for now First Republic looks like a candidate for the watch list.

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

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