Research Report on Synovus Financial (SNV)

8/14/2019 Research Report on Synovus Financial (SNV)

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The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Playing the Devils AdvocateA Report on Synovus Financial (SNV- $1.92): 12/18/09

Usually the act playing the devils advocate involves taking a contrarian position. So, in the case of a stock that istrading at about $2, down from over $30 in 2007, presenting a pessimistic outlook for the stock might not seemparticularly bold or unique. However, Tom Brown from bankstocks.com recently wrote a bullish piece on Synovus

Financial(SNV) that argued pretty persuasively that the bank was undervalued at the current price, based on somereasonable assumptions about future earnings. Brown also contends that the bank likely has sufficient capital tosurvive the credit cycle without diluting shareholder further by issuing shares. While I do not necessarily disagreewith his overall thesis that SNV has the potential to be one of the survivors, based on my analysis of the bankscapital position and credit trends I do not agree with Browns assessment of SNVs near term prospects.Specifically, the data I have analyzed continues to highlight some troubling developments in the banks loan bookthat could eventually force the company to raise new capital and could impair earnings for many quarters to come.Clearly, being an investor with a long time horizon, short term issues should not influence my opinion of the stockas long as I believe the company will make it through alive. Therefore, let me start off by addressing each one ofBrowns arguments and then close with what I think it all means for the long term.

Point 1: The worst-performing loan portfolios have begun to shrink. In any major credit cycle,different loan categories will have vastly different default frequencies and loss severity. For Synovus, the

worst portfolios, both in frequency and severity, have been (by product type) loans to homebuilders and (bygeography) loans in the Atlanta metro area and in Florida.

Brown is spot on when he points out that the residential construction book, especially in Atlanta and in Florida, hasbeen SNVs worst performing portfolio. As of Q3 2009, $507.5M of this $2,513.3M book was classified asnonperforming. If an NPL ratio close to 24% (up from 19.2% in Q2) sounds high thats because such a rate wouldhave been unfathomable just 3 or 4 years ago. Fortunately for SNV, the size of the 1-4 family construction anddevelopment portfolio and its potential impact on earnings has begun to shrink. Specifically, this portion of the bookwas down to $2,513.3M ( 9.5% of the total book) in Q3 2009 from $2,963.6 (10.7% of the total book) in Q2. Also,given how early the southeast portion of the US began to experience the housing bust, it is likely that many of theseconstruction loans have experienced the bulk of the writedowns they will cumulatively see. However, in my view,problems with construction loans represent only the first wave of writedowns and losses for SNV and the otherregional banks. The second wave, which consists of prime mortgage defaults, commercial real estate writedownsand losses on C&I loans, is just starting to play out. In particular, when combined with the lack of consumer creditand substantial unemployment, the negative derivative impacts of the housing crisis are really starting to impactother types of businesses and loans. Take a look at the following chart and you can see what I mean:

Q1 2009 Q2 2009 Q3 2009

Net Charge Offs: $246.0 $355.0 $497.0

Non-Accrual:

1-4 Family Construction $231.8 $209.8 $166.6

Other Construction & Land 419.3 548.5 606.9

Total Construction/Land $651 $758.4 $773.6

Farmland 3.8 2.8 2.0

1-4 family Mortgage 131 175.7 192.6

Multifamily 13.5 17.6 12.7

Nonfarm/Non-residential Mortgage 258.3 275.3 397.4

Non-Accrual Tied to Real Estate $1,057.6 $1,229.8 $1,378.3

Total Non Accrual $1,214.7 $1,378.8 $1,469.8Source: FDIC.gov

I compiled the above data from the FDICs website and it only includes loans classified as non-accrual (totalnonperforming assets also includes other real estate owned and loans 90+ days past due and still accruing interest).Now, the bank has disposed of some underperforming loans and this may be skewing the data a bit, but I believe thetrend is clear. We can see increasing net charge offs (to be addressed more later on) and increasing non-accrual
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loans in the following portfolios: construction, 1-4 family residential mortgage and nonfarm/non-residentialmortgage (commonly known as commercial real estate mortgages). I think this data definitely corroborates whatBrown is arguing in point number one. Non-accrual loans in the 1-4 family construction book were down to$166.6M in Q3 2009 from $231.8M in Q1 2009. But look at the close to 50% increase in non-accrual loans havingto do with other construction and land. Also look at the dramatic increase in 1-4 family mortgage delinquencies andin commercial real estate non-accruals. This represents the second wave of delinquencies that I believe are going tokeep credit losses elevated, require SNV to continue to build its reserve, and ultimately require additional capital.

Point 2: The inflow of new nonaccrual loans will continue to slow.

I addressed this point above but will say a few more words here. Since the company is on pace to sell $600M introubled assets during Q3 and Q4, it is important to look at new additions to non-accruals and not just the change inbalance between one quarter and the next to evaluate whether there has been an increase or decrease in problemloans. Brown estimates that additions to non-accruals will only be $650M in Q4 2009 versus $756M in Q3 2009.Apparently, these beliefs were confirmed on his recent trip to visit the management team. Unfortunately, if this doesoccur I believe it will only be a temporary reversal based on the fact that while construction NPLs will continue todecrease, that reduction will eventually be more than offset by new problem loans in other categories.

Also, I am having trouble assessing the impact of this change, but it looks like SNV may have moved the goal postsa bit in terms of classifying NPLs. From the Q3-2009 10-Q:

During the third quarter of 2009, Synovus revised its definition of nonperforming loans to exclude accruingrestructured loans. Such loans are not considered to be nonperforming because they are performing inaccordance with the restructured terms. Management believes that this change better aligns our definition ofnonperforming loans and nonperforming assets with the definition used by our peers and therefore improves thecomparability of this measure across the industry. All prior periods presented have been reclassified to conformto the new presentation Accruing restructured loans were approximately $193 million at September 30, 2009,compared to $18 million at June 30, 2009. At September 30, 2009, the allowance for loan losses allocated tothese accruing restructured loans was approximately $29.7 million. (Emphasis added)

Now, the company does not give a lot of additional info on these restructured loans, but from what the national dataon housing-related re-defaults tell us (up to a 70% rate when modifications only include interest rate changes), thesemay be some of the riskiest loans in the portfolio. If all $193M of these loans were classified as NPLs then total

NPLs would increase by 11% and companies allowance to NPL ratio would look even more insufficient.

Point 3: The level of net chargeoffs should start to decline.

The first reason that Brown states for a potential decline in NCOs is that he believes that new non-accruals will bedown quarter on quarter. According to Brown, the company takes an immediate 15-20% haircut on non-accrualloans in the form of a charge off. So, if new non-accruals are down so too will NCOs. Since we obviously havediffering opinions on this I will move on to the next point. Second, in Q3 SNV wrote down existing NPLs by$135M and Brown makes the valid point that it is unlikely that the bank will take such a large hit on existing badloans again in Q4. When you combine cumulative writedowns and specific reserves associated with each loan, SNVhas allowed for a 46% cushion (Brown uses 42% as his figure but the Q3 2009 10-Q claims the number is 46%) thatshould be enough to limit significant writedowns in existing NPLs.

However, the company plans to complete its sale of up to $600M in problem assets (including other real estateowned) by the end of Q4 and that may cause SNV to recognize losses before it would have if it had held onto theloans. Specifically, in Q3 the company recognized $76M related to charge offs on loan sales. Unfortunately SNVdoes not break out what portion of the $339M of assets sold was loans and what portion was OREO so it is hard toestimate exactly the magnitude of the writedowns on each. However, it is important to note that whatever thepercentage is, it is likely in addition to the initial 15-20% hit the bank takes when a loan gets classified as non-accrual. Also, since SNV may be unable to sell the most distressed assets, the assets sold in Q3 may have beensomewhat cherry picked and the associated writedowns may not accurately represent the overall losses embedded inthe portfolio. In fact, based on the $600M target of asset sales SNV will likely have to realize additional losses onthe $261M in assets remaining to be sold in Q4 and NCOs may not actually decline at all.
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In any case, under the assumption that SNV is eventually going to have write off existing dodgy assets whether itsells them or not, a temporary postponement of NCOs in a single quarter should not influence the overall analysis ofthe companys long term value.

Point 4: The level of OREO writedowns should also start to decline. Synovus had $606 million of creditexpenses in the third quarter, including an unusually high $101 million in OREO expenses. OREO writedownsshould decline for three reasons. First, new nonaccrual loans moving into OREO have been written down tolower values than in prior periods. Second, the company will be less aggressive in OREO disposition. Finally,loss content of future OREO dispositions will be lower than in the past because properties being disposed ofnow tend to include more income-producing properties and less land than they did before.

I surmise that Brown is correct on this assumption, barring a huge spike in foreclosure activity in Q4 2009. But, aspointed out above, if the company is going to eventually have to write down OREO to the lower of cost or fairvalue, the timing of the writedowns is not particularly important to someone who wants to buy and hold the stock.Plus, I am concerned that the number of foreclosures stemming from commercial real estate loans and 1-4 familymortgage defaults are going to keep OREO costs elevated and negatively impact earnings.

Point 5: Loan loss reserve building has slowed and will soon stop; reserves will begin to be drawn down

next year.

Not only do we expect this to continue but, next year, as more loans are upgraded, we believe thecompany will begin to bring its loan loss reserve (3.5% of total loans) down by provisioning less than itsquarterly level of net chargeoffs.

This is where I think I disagree with Brown the most. The idea that SNV does not have to continue to build itsreserve seems unfounded. Going back to the first chart that shows the persistent increases in non-accrual loans, Icannot see a justification for SNV solely matching its Q3 provision to net charge offs. A conservative ratio ofallowance for loan losses to nonperforming assets is 100%. This means that for every $1 of NPAs, the bank setsaside $1 for potential losses. While this may be unnecessarily cautious in some cases, it looks to me like SNV maybe under-reserved. Take a look at the following chart:

Provision for Loan Losses YTD Q3 2009NCOs $1,098.0 $497.0

Provision $1,418.5 $496.5

Provision to NCO Ratio 129.19% 99.90%

Allowance Q2 2009 Q3 2009

Allowance for Loan Losses $918.7 $918.5

Allowance to NPAs 53.47% 52.56%Source: Company reports


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As of Q3 2009, the ratio of the allowance to NPAs was only about 52.6%. Keep in mind that one of the reasons thisnumber did not decrease even further was that SNV sold $339M in troubled assets and subsequently took largelosses on those sales. In particular, new non-accrual loans in Q3 were $756M and the company (on net) did notincrease its reserve accordingly. Even worse, the quarterly provisioning for Q3 did not even cover the NCOsrecognized in that period, a fact that indicates to me that SNV is barely keeping its head above water. These actionsare not indicative of a conservative management team that is being realistic about potential future losses. My theoryis that the bank is actually concerned about its capital levels and does not want reduce its common equity evenfurther by increasing the allowance for loan losses. Also, under-provisioning allows the company to report higherearnings (or less negative earnings) than it would otherwise. It is in situations like these that I like to create a pro-forma valuation for a bank under the assumption that it had an allowance to NPA ratio of 100%:

This table shows what multiple to book and tangible book SNVwould be trading at if it matched its allowance to actual NPAs.This is a conservative way to evaluate banks, but in the currenteconomic environment an analysis like this is a necessity. Incomparison to the multiples to stated book and tangible book of.29x and .30x, respectively, under this scenario the multiplesjump to .47x and .49x. Also, gross loans to tangible equity (ameasure of leverage) spikes from 12.2x to 19.9x and thecompanys tangible equity to tangible assets (TE/TA: a measure

of capital sufficiency that I put above all others) drops from6.23% to 3.93%. Bank analysts look for TE/TA levels at orabove 5%, especially for banks that are seeing their loan booksdeteriorate. This is a perfect example of how under-provisioning and not recognizing losses can make a bank lookhealthier than it really is. I cant say for sure that SNVsmanagement team is being too optimistic, but this analysissuggests that (especially given the continued increase in non-accrual loans) SNV may be forced to raise new capital if it

wants to have a sufficient buffer against future losses.

Given our forecast for improving credit, declining credit costs, and modestly improving pre-tax, pre-creditcost earnings, we expect manageable operating losses and a modest decline in the companys capital ratios

before they start to sharply improve in the second half of 2010 and in 2011. Under this scenario, we do notexpect a dilutive capital raise!

In addressing the capital issue, Brown includes a chart that highlights a few of the banks capital ratios. However, Ido not put a whole lot of stock in Tier 1 ratios and claims of being well capitalized. How many banks wereconsidered well capitalized the day before the FDIC walked in and shut them down? This is precisely why I liketo look at TE/TA and leverage ratios such as Gross Loans/TE to get a handle on capital sufficiency. Based on thesemetrics I do not believe SNV currently has strong enough capital levels for potential investors to be comfortable. Tomake matters worse, Brown indicates that he expects the capital levels to actually decrease even further, partiallyoffset by some balance sheet shrinkage and gains from asset sales. Honestly, I am not sure what he is referring towhen he asserts that SNV will realize gains from asset sales. Unless the company is planning on selling offprofitable business lines, it appears that sales of loans and OREO are actually leading to significant losses andfurther capital destruction.

Future Earnings Analysis

Now that we have finished assessing the balance sheet, it is necessary to look at future earnings and the incomestatement. The truth is, no matter how ugly balance sheet is, if the SNV can survive the cycle (and even if it doeshave to raise some more capital) and get back to somewhat normal earnings levels, the stock at the current valuationmay be very attractive. From Brown:

Assuming the company turns profitable in the third quarter of next year, its initial earnings will be tax-free. Then after a few quarters of profitability, the company will be able to reverse its deferred-tax asset

Q3 2009 Pro Forma B/S Stock Price: $1.92

Allowance for Loan Losses $918.5

Total NPA 1747.5

Difference -$829.0

Stated Total Assets $34,610.50

Stated Net Loan Book $25,413.2

Tangible Common Equity $2,154

Common Equity $2,211

Increased Reserved 829

Adjusted TCE $1,325

Adjusted CE $1,382

Gross Loans/TE 19.9x

P/TBV 0.49x

P/BV 0.47x

TE/TA 3.93%


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reserve, which today totals $331 million. This would boost the companys capital ratios by around115basis points and boost tangible book value by 70 cents per share, or 15%...

Given this [estimated] level of income [$685M], $160 million of normalized credit expenses, a full taxrate, no TARP preferred dividends, and 490 million shares outstanding, we see normalized EPS of 70 centsper share. Assuming a below-historical normal P/E multiple of 12 times, we see the stock trading between$8 and $9 over the next two to three years, making it a potential five-bagger from todays stock price.

First, I am far from an expert on deferred tax assets and loss carry-forwards, but if what Brown says is correct thefuture tax savings could be substantial. I am not sure how to handicap this since it is hard to know what the next fewquarters will look like in terms of profitability. As mentioned above the level of provisioning is a huge factor indetermining whether or not a bank is profitable in a given period. Accordingly, I would rather focus on what SNVcould be worth in a more normal operating environment, given that the company survives this credit cycle. Brownestimates that normalized EPS are in the $.70 range and if a 12x multiple were applied to those earnings the stockcould be worth between $8 and $9 dollars. On a similar note, here is my analysis based on pre-tax preprovision/credit losses earnings (eloquently known herein as PTPPE):

Pre Tax Pre Provision Earnings 2004 2005 2006 2007 2008

Net Interest Income $860.7 $965.2 $1,125.8 $1,148.9 $1,077.9

Non Interest Income 1521* 327.4 359.4 389 396.6Non Interest Expense 1588.4* 646.8 764.5 803.3 986.3

PTPPE $793.3 $645.8 $724.0 $750.3 $624.9

Shares Outstanding 310.3 314.8 324.2 329.9 329.3

PTPPE per Share $2.56 $2.05 $2.23 $2.27 $1.90

Closing Stock Price $28.58 $27.01 $30.83 $24.08 $8.30

P/E Multiple 11.18x 13.17x 13.81x 10.59x 4.37x

Provision for Losses 75.3 82.5 75.1 170.2 699.9

Foreclosed RE Expense 0 0 3.3 15.7 136.7*Includes revenues and expenses from payment processing that were not present post 2004Source: Company filings and my calculations

In the above chart I calculate PTPPE by adding net interest and non interest income, subtracting non-interestexpenses and adding back foreclosed real estate expenses. Over the last 5 years the average PTPPE per share was$2.20 and the average multiple that the stock traded at in relation to that figure was 10.62x (clearly dragged down by2008 data). The reason I am not trying to estimate EPS like Brown did is because it is very difficult to make anymeaningful assumptions about future credit losses and foreclosed real estate expenses. Just look at the disparitybetween the provision as recently as 2006 and the full year provision for 2008. Having said that, it is important to becareful not to extrapolate the banks current issues too far into the future and to make sure to keep in all that thegovernment might do in the coming years to help boost bank profitability.

Based on my assumption that the company should increase its allowance by about $830M to be safe, to get TE/TAback up to 5% SNV would have to raise an additional $375M in capital. At $2 a share, that implies an increase inshares outstanding of 187.5M, bringing the total to somewhere around 520M. From there, assuming a conservativerun rate PTPPE of $625M implies per share earnings of $1.20. If the company ever traded at 10x that amount thestock could eventually get to $12. Of course, it could take years for a normalized scenario to play out, especially

given my expectations of future credit losses, but the analysis of earnings does indicate that Brown may be on tosomething with SNV.

Now, I have to temper the optimism a little bit with the following data. I use a basic guideline for valuing theappropriate multiple of book value for bank as follows: a bank that earns a return on common equity (ROCE) of10% should trade at 1x book value and a bank that earns an ROCE of 20% should trade at 2x book value. WhileSNV has been able to achieve a strong net interest margin (NIM) over the years, the banks ROCE has not beenparticularly noteworthy:


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dependent on a number of assumptions that could prove to be woefully incorrect. First, there is no way to know if

the bank will need to raise capital, how much it will need and how dilutive the share issuance will be based on the

stock price at the time. Next, because of the difficulty in anticipating the direction of unemployment, housing prices

and general economic trends, estimates of future credit losses are likely to be unreliable. Finally, applying historical

rates of returns and multiples in trying to establish intrinsic value is, at best, an imprecise method of valuation.

Furthermore, there are plenty of company-specific risks as well. The bank could have to raise substantially more

capital than I have estimated. The capital markets could be essentially shut down at the time SNV recognizes the

need for additional capital and could subsequently become essentially insolvent. Management does not appear to be

publicly acknowledging the continued deterioration in the loan portfolio or the spike in non-accruals in second wave

categories such as commercial real estate and C&I loans. I fear that that some of the under-provisioning that appears

to be going on is based on the hope that the real estate markets begin to turn around as the economy shows

preliminary, but very tenuous signs of recovery. When combined with my suspicion that the company is loathe to

issue more shares and dilute current shareholders further, this extend and pretend philosophy could be very

dangerous.

In conclusion, an investment in SNV is not for the faint of heart and anyone interested in accumulating shares would

be wise to follow the company very closely. If you cannot already tell, my experience with the management teamsof regional banks has led me to be very distrusting and skeptical of any and all pronouncements or forecasts. The

people who run these banks have an incentive to downplay current and future problems because in the end banking

is business built on trust. Additionally, with the Federal Reserve handing out money and the yield curve so steep, it

is easy to see why banks would try to extend and pretend in an attempt to earn their way out the cycle. Accordingly,

it is more important to monitor the actions of the bank in terms of recognizing losses, adding to reserves and selling

off troubled assets than to rely on the claims of management.

From my perspective, I would be inclined to hold off from investing in SNV until management either acknowledged

the need to raise capital and/or started to increase its reserves again. I believe that current investors are likely to be

substantially diluted through additional share issuance and new investors would be better served being patient.

However, assuming the banks franchise has not been severely impaired and SNV ultimately raises enough capital to

make it through the cycle, I think there is a legitimate possibility that the shares could double over the coming years.

Research Report on Synovus Financial (SNV)

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