Shares of Regions Financial (NYSE:RF) plunged over 4% Friday as investors digested a poor set of earnings, and shares are now down over 37% year to date. Unfortunately, the credit deterioration of its loan book was worse than expected, but more troubling, it is not entirely clear that Regions has reserved sufficiently against likely further deterioration. As a consequence, we may see further degradation of book value, and while the company plans on maintaining its dividend in the third quarter, I see a material risk of a dividend reduction to preserve capital.
(Source: Seeking Alpha)
Regions swung to a net loss of $237 million, or $0.25 per share, in the second quarter. For comparison, analysts expected the company to have a net profit of $0.06/share. The primary driver of the company’s net loss was its bigger-than-expected allowance for credit losses of $700 million. For comparison, it had increased reserves just $250 million in Q1. As the economic fallout of the COVID-19 recession becomes more defined, RF is preparing for a more severe impact on its loan book.
Now, higher reserves are not necessarily bad news. When a bank determines reserves, it creates an economic base case, estimates losses on its existing loan book under that case, and reserves accordingly. Given no one knows the future, different banks can realistically have different economic forecasts and different reserve policies. As such, reserves may not be “worse.” They just may be taken against a worse economic backdrop. In Regions’ case, the economic scenario strikes me as reasonable, but I am unconvinced if it plays out, that this $700 million allowance will be Regions’ last.
As you can see below, Regions expects unemployment to end this year at 9.1% and next year at 7.0%. For comparison, the Federal Reserve is expecting 9.3% and 6.5%, respectively, so Regions is expecting a slightly better recovery this year that stalls out a bit more in 2021 than the Fed expects. These forecasts are similar, and both seem defensible. We can say that Regions is not using an overly optimistic economic scenario.
Now, further educated guesswork is needed by banks to determine what the losses on their loans will be given this economic scenario. To be clear, absent granular loan-by-loan data, this is imprecise work. But even with that data, reasonable people can disagree as the future is uncertain. There will undoubtedly be some loans that surprisingly go bad and others that shockingly pay off in full. We cannot say to the dollar how many loan losses will occur, but we can gather a sense of whether the risk is of more-than-reserved losses or fewer losses. In Regions’ case, the risk is higher.
So in the second quarter, Regions’ total loan portfolio grew from $83.25 billion to $91.96 billion. However, its participation in PPP, where it is unlikely to face economic risk, accounts for about $5 billion of this increase. Adjusting for this, the company has about $44 billion of business loans, $12.8 billion of real estate, $14.9 billion of residential first mortgage loans, and $15 billion of other consumer loans. RF is primarily a business and real estate lender, which is not atypical among regional banks. In this recession, that may actually be a headwind because the consumer sector has received far more fiscal support than the corporate sector. Enhanced unemployment benefits and stimulus checks have driven personal income higher than one year ago whereas corporate profits will be down materially.
Now, commercial real estate is in the eye of the storm. Malls have seen tenants skip payments; even though things improved in June, only 66% of hardline retailers paid their rent. Increased work from home trends may also structurally dent demand for office properties. On the corporate side, it very much depends on the sector. Many consumer products companies are doing fine while there have already been a wave of energy bankruptcies.
$1.37 billion of RF’s loans are to the energy sector, of which 48% are criticized, $1 billion to hotels, of which 27% are criticized, and $2.5 billion to retail real estate (i.E. Malls), of which 25% are criticized. Criticized assets are assets the regulators see as “rated special mention, substandard, doubtful, and loss.” In other words, regulators have raised flags over $1.5 billion in loans just in these sectors. In total, RF’s criticized business loans surged about 68% to $4.2 billion, nearly 10% of its business loan book.
Now, not every criticized loan will default, and RF will recoup some recovery on most defaults, but this is a very significant pick-up in criticized business loans. Historically, bank loans recover 70%, though increased leverage and looser covenants create a risk of weaker recoveries. Even if no new loans become troubled, its business loan book could be sitting on over $1 billion of losses, and its commercial real estate and consumer loan books will also have some losses.
Excluding PPP, allowance for credit losses were 2.68% of total loans (about $2.5 billion), well under its criticized loan rate. For perspective, JPMorgan Chase (JPM) has reserved against 3.5% of its loan book, and Citigroup (NYSE:C) 3.89%. This is where RF’s relative reserving has me concerned. It has plenty of exposure to troubled sectors, and yet its reserves both look low vs. A large peer and its own loan book’s credit migration. If Regions were to see a similar loss rate as JPM expects, it needs to reserve another $750 million, meaning its Q2 reserves were only half of what was necessary.
This is particularly relevant for shareholders because RF has eroded 100bp of equity capital over the past year, and it is now below its target of 9.0%. Now during periods of economic stress, it is prepared to temporarily run below 9% and then rebuild capital by retaining earnings. As such, it will still pay out its Q3 dividend, giving shares a 6% dividend yield. However, another round of provisioning will further erode capital or force the company to take taxable gains on investment to support capital. In this scenario, RF could be forced to cut its dividend to protect its balance sheet.
RF is running with a low margin of error. If its loan losses develop worse than expected, or if the economy takes another leg down, forcing a downward revision of its macro forecasts, we could see another $500+ million in reserves this year, taking capital down 0.5% and leading to a dividend cut.
Even if it has proven to taken enough reserves, I don’t see upside in shares. Due to losses on its loan book, tangible book value has fallen from $11.67 last quarter to $10.42 this quarter, leaving shares essentially 1x book value. But lower interest rates are pressuring net interest margins from 3.44% in Q1 to a $3.30% run rate, a $150 million annual pre-tax income hit (~$0.15/share), leaving the company with at or below $1.00 in earnings power in 2021.
In the bear case with a dividend cut, shares can trade down to $8 whereas I see them struggling to move past $11. Indeed, at these levels, shares look like an attractive short. For those inclined, I would consider pairing a short against a long in Ally (ALLY), which trades at a deeper discount to book value with a more consumer-facing loan book. For long-only investors, I would rotate RF holdings into a name like Ally. The risk/reward is skewed to the downside.
Disclosure: I am/we are long JPM, C, ALLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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