Motley Fool Hidden Gems Investing - Banking On The Home Court Advantage

Episode Date: January 18, 2024

Regional banks are facing strong competition in the battle for your dollars. (00:21) Matt Frankel and Deidre Woollard discuss: - How new rules could change what you pay in overdraft fees. - Why banks are socking away money for credit losses. - The potential advantage for regional banks. (17:31) Asit Sharma and Mary Long take a medium dive into Paycom and discuss a product that could be too good for its own good. Companies discussed: TFC, DFS, USB, WFC, PAYC, JPM, PAYX, PCTY, ADP, ORCL Claim your Epic Bundle discount here: www.fool.com/epic198 Host: Deidre Woollard Guests: Asit Sharma, Matt Frankel, Mary Long Producers: Ricky Mulvey, Mary Long Engineer: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

You gotta try breakfast at A&W. You gotta try breakfast at A&W. And what better way than with a delicious Pret Organic Coffee, starting at just $1 all day, every day, now until December 31st. You gotta try breakfast at A&W. At participating A&W locations in Ontario. Welcome to Motley Fool Money. I'm Deidre Willard here with Motley Fool analyst, Matt Frankel. Matt, how's it going today? Pretty good. It's been a while since I've done one of these with

you. I'm happy to be here. Well, I always like to tap you if we're going to talk about banking and financials, because you're one of the people who studies that. You get it in a way that I don't think I quite do. And we're going to talk about some regional bank earnings. But before we do, I want to talk about something the Consumer Financial Protection Bureau announced yesterday that I'm trying to make sense of that is around overdraft protection. So it sounds like what they're going after is those large overdraft fees that nobody likes. They say they can save people about $3.5 billion. What is this, and how much of an impact is it going to have on banks? First of all, yes, I'm a bank investor, but I'm also a human being first, so I think this is a

good thing. Yes, banks make money off these, and this will help people. But you have to realize that the average person who takes an overdraft are the bank's most vulnerable customers. and the banks are literally taking money from people who don't have any money. And it's something that's needed to be fixed for a while now. But just looking through the numbers, this will have an impact on banks for sure. Banks make about $9 billion a year on overdraft fees. And of course, the banks are pushing back on this rule. I mean, they're a business at the end of the day.

And they're arguing that this is going to make it harder for banks to offer overdraft protection to customers if they're not allowed to charge for it. But on the other hand, the CFPB proposal clearly gives banks permission to recoup their costs. So, they're not going to lose money by extending overdraft protection. They could charge a reasonable interest rate if they want to give an overdraft loan, or they could charge a reasonable fee, which $35, if I overdraft my bank account by $10, is that really a reasonable fee? No, that's 350% interest, and most overdrafts are paid back within three days.

So, this is something that's needed to be reformed for a while. A lot of banks make a lot of money off these, but it's an income stream that I have to say I'm happy to take the hit on as a bank investor. Yeah, I would agree with that. It's interesting because you've got the two pathways there where they can either do the loan or they can do that charge. So, if they do the loan, it sounds like then it sort of functions as any other traditional loan and gets subject to a whole bunch of legislation that way.

Yeah, they have to disclose the interest rates and things to that effect. And I mentioned that banks make $9 billion on overdraft fees. That's between the 175 largest banks. That's not that much. It sounds like a big amount of money, and it is. But I mean, JPMorgan Chase could afford to absorb that and still be profitable. So it's not a giant amount of money in the grand scheme of things. This is not a giant revenue center for the banks. At the end of the day, banks still make the bulk of their money on things like charging interest on loans, investment banking fees, mortgage origination fees. This is not a giant fee income stream for most banks. It will be a hit, but it's not going to decimate their quarterly earnings or anything

like that. Yeah. And it's just for the big banks with over, I think it's about over $10 billion. So, it's 175 banks, institutions total. Yeah. This is not going to hurt. Your regional banks can still charge whatever they want for, or your local banks can still charge pretty much whatever they want for overdrafts under this proposal. They're going to have to lower their fees to compete. But yeah, this only affects banks that have over $10 billion in assets. And I mean, pretty much every bank that you is a household name in America. Yeah. Well, let's talk a little bit about those regional banks. Because last week, we had the big banks reporting. It seemed to me to be a mixed bag. The quarter before was a very

big quarter for them. This one was a little different. But now we're looking at smaller and regional banks. So what kind of questions are you asking yourself as you look at some of these earnings coming in? Well, like you said, it's a mixed bag. So it's definitely on a case by case basis what I want to see. Net charge off rates are a big thing right now. It's looking like we're going to get the so-called soft landing in the economy. A recession would be terrible for banks. Recessions lead to higher defaults, not only that, but much lower loan demand, so they're not originating many new loans. And net charge-off rates at the moment aren't out of control. I'm sure we're going to talk about this a little bit more later,

but that's one big thing I'm watching. Deposit bases, a lot of bank customers, myself included, have moved a lot of their balances away from the big banks and even the big regional banks that don't pay very much on checking and savings accounts in favor of higher-yield online banks, CDs. Banks are realizing a little too late that they need to raise their deposit yields to compete. Some banks have done a great job of this. Capital One is one example that's been very proactive with competing with the online banks with high-yield CDs and things like that. But banks like Bank of America and Wells Fargo, not so much. One thing I'm watching is how much of the deposits are still flying out the door, and the answer is quite a bit. Net interest margins

are another thing. One thing that people don't realize is, yes, higher interest rates are good for bank loans in the sense that now instead of a 5% average rate on auto loans, you're getting about a 10% average rate on new auto loans. But the loans on the bank's balance sheets, for the most part, the majority of them, were originated in pre-high interest rate times. Most of their loans are not high yielding, but 100% of their deposits are becoming higher yielding. The higher interest rates are actually being more of a negative on the bank in terms of interest margins than a lot of investors would expect. Finally, I'll stop rambling after this, The FDIC's special assessments, speaking of regional banks, are hitting all of the bigger

banks, including a lot of the big regional banks, like the ones we're going to talk about, because of those bank failures we had in 2023. Think of this as if you're HOA, if it has to replace the pool, you might get a special assessment that year that helps them cover the cost of it. The FDIC had to replace a lot of people's money with bank failures, so a lot of the banks are getting hit with special assessments in order to cover it. Yeah, I've been watching that in the earnings, and it's sort of like a shorthand to see how big the bank is, depending on how much they had to pay as part of this special assessment. Yeah, and some of them are pretty high.

Yeah, some of them are very high, especially JP Morgan. You mentioned credit provisions. I want to talk quickly about Discover Financial, which is not a bank, but also not a bank, because like Amex, it takes on the loans itself, and they added a billion to their credit loss provisions. So like you said, the banks are still increasing these provisions. And most of the net losses so far that we've seen are still below pre-pandemic levels, but they are rising. So should we be worried yet? I'm at the point where I'm like, an ear is up. I'm a little worried. Like I said before, it's kind of on a case-by-case basis. Some banks, it seems to be progressing better than others. And you're right, the banks are generally increasing

their provisions, which means they have enough in reserves to cover what they expect to lose, then a little bit more. Wells Fargo, for example, raised their provision by 34% year-over-year in the fourth quarter, fueled by credit cards and commercial real estate loans. Surprise, surprise. I know we'll talk about commercial real estate a little bit later. But if you look at the two big regional banks that reported this week, U.S. Bancorp and Truro Financial, one is significantly lower than pre-pandemic rates, that would be U.S. Bancorp, and that charge-off rate is three basis points lower than in comparable 2019. Remember, in 2019, the economy was doing very well. That's a strong pre-pandemic time. But on the other hand,

Truist is about 10 basis points higher than it was in comparable 2019 times. Not only that, right now their net charge-off rate is 0.5%. They're expecting that to rise to 0.65% in 2024. That would be significantly higher than pre-pandemic levels. Like I said, it's kind of a mixed bag. Truist is one of the few banks that actually gives forward guidance on that. It's really tough to know what management's thinking when it comes to net charge-offs in a lot of cases. But it's making me take notice. It's making me a little bit cautious. A lot of banks are projecting revenue to decline a little bit year-over-year in 2024, and that's a big reason for earnings to decline. Well, you just mentioned U.S. Bank Corp. I was listening to

their earnings call. One of the things they talked about was the cost of retaining customer deposits and that they're really having to go out there and spend more money than they used to. Is this something that's impacting a lot of the regional banks? Oh, absolutely. U.S. Bank Corp mentioned it. Truist actually gave some really great figures on that. That interest margin fell by 27 basis points year over year. Here are the stats. This is what I was talking about with a lot of the loans on their balance sheet are still paying low yields from years ago, while all of their deposits are now higher yielding. The yields on Truist's earning portfolio are up by 95 basis points year over year, meaning that their average loan is paying

0.95 percent higher of an interest rate than it was a year ago. The average cost of its interest sparing liabilities, which primarily means it's deposit base, is up by 164 basis points year over year. So 1.64%. And it's not only the deposits are at higher yields, the cost of banks to, say, issue long-term debt is a lot higher than it was. The cost to borrow, this is what the federal funds rate's all about. And the Fed's benchmark interest rates are the interbank lending rates. those are a lot more so banks are paying a lot more on capital than they're making on loans but they're still not paying as much as a lot of the higher yielding options like online cds and things like that so the cost of retaining customer deposits is a concern and not only is it a

concern it's yes it's costing more but it's not terribly effective if i'm looking at their deposit basis. Yes, banks are retaining their deposits, but Truist lost a total of $23 billion of deposits over the past year. $23 billion. This is a regional bank. This isn't one of the giant ones. They're a regional bank that operates in pretty attractive market environments in the Sunbelt region. Yes, they need to pay more to retain their deposits, but customers are still looking to maximize yield. You're not going to do that with branch-based banks for the most part. Truist is interesting, because they reported their earnings. They had a loss, and they're forecasting a revenue drop of about 1% to 3% for the fiscal 2024. But they also talked

about that regional advantage that you just talked about. So, they're in the Sunbelt area. And I was thinking about this as an overall look. So, last year, after the banking crisis, we had that flight to safety, to the big banks. Then we had what you talked about right now with the rate chasing. All of a sudden, everybody realized, hey, if I put my money over in a CD or in one of the online banks, maybe I can get a better rate. Now, I'm not sure what the financial story is. And looking at Truist, is that regional advantage? They see it as a huge thing. I don't know. What do you think? I would say yes. I'm in Truist country. I don't know if there are Truist branches up where you are. I'm definitely in Truist country. Everyone knows they came from

BB&T and SunTrust. If you didn't know that, you know that now. SunTrust was a big bank in Florida. That's where I had my bank account when I lived down in Florida. It's generally market environments, not all of their markets, but most of their markets have above-average wage growth, above-average job growth, positive net migration, which has been a big trend since the pandemic started into the Sunbelt region, and relatively affordable housing costs, which is very attractive. People can still afford a mortgage there. So, I think it is an advantage. It's going to be more of a long-tailed advantage, however. I think I could see it fueling growth better than, as opposed to a bank that's based primarily in New York and New Jersey,

where you're seeing population outflows over time, or at least slower net migration. I'm from New Jersey, and most of my friends have gotten out of there. No offense to New Jersey. But I do see it as an advantage, but not a big enough differentiator that that is the investment thesis all by itself. Well, with regional banks, we've also got commercial real estate as a bigger portion of things. You and I can't get together without talking about real estate. I'm pretty sure that's in our contracts. So let's do that. So with Truist, you've got a fair amount of commercial real estate loans. We both keep an eye on this. Last year, the big concern was office. But I'm also starting to look at multifamily for signs of weakness. This is traditionally a really safe

area. It's around 33% of Truist loans. There's not a vacancy problem with multifamily the way there is with office, but there is a rent growth slowing problem. What are you thinking about commercial loan liability for regionals right now? It's really interesting you mentioned multifamily. Like you said, everyone always talks about other property types, specifically office, when you hear about the commercial real estate crisis, it's usually referring to office. There's a lot of empty office buildings in my town, I'm sure there's a bunch near you. But multifamily, it's a really interesting thing in that there's a lot of refinancing risk that's going to happen in the next few years.

I recently interviewed Willy Walker, the CEO of Walker & Dunlop. They're the biggest multifamily focused commercial real estate finance company in the U.S. He pointed out that over the next three years, 2024 through 2026, there are over three times as much multifamily loan volume that will need to be refinanced as in the last three years. Multifamily loans are not like the mortgages that you and I would get to buy a house in that you just pay your mortgage, the balance goes down over time. They're generally interest-only loans that need to be refinanced every so often. A lot of them are coming due within the next few years. I'd be curious to see how many of those are truest loans. I only know the data for Walker and Dunlop's loans because banks don't break out

individual loan data usually. But I would have to say that that refinancing proportion is probably consistent with what you're going to find in Truist portfolio. That's a big risk, especially if interest rates stay elevated, and that's a big if right now. Most experts expect interest rates to fall over the next year or two. The question, it's going to be a real balancing act between how much refinancing volumes coming due and the interest rates you can get because you know as well as I do, commercial real estate assets derive most of their value from how much they earn their owners over and above the cost of ownership. There's not a vacancy problem in multifamily. There's still a housing crisis in the United States. There's a lot of demand.

The U.S. economy has the ability to absorb, depending on who you ask, about three million new housing units. Most of that would be multi-family housing, not single family. There is a lot of demand. That's the good thing, but there is that refinancing risk, and that's what I would be keeping an eye on. Yeah, me too, especially. The interest rates remain this unknowable question for the future. Thanks for breaking it down with me today, Matt. Of course. Glad to be here. We talk about a lot of stocks on the show, but it's just a peek at The Motley Fool's investing universe. This year, we're rolling out a new offering. It's called Epic Bundle.

The service includes seven stock recommendations every month, model portfolios, and stock rankings, all based on your investor type. We're offering Epic Bundle to Motley Fool money listeners at a reduced rate as a thanks for listening to the show. So for more information, head to www.fool.com slash epic198. We'll also include a link in the show notes for you. Up next, Asit Sharma joins Mary Long for a closer look at a company that might just help you get paid. Paycom is a software as a service, a SaaS company that provides human capital management solutions. Basically, what that means is it's a company that helps other companies keep track of their employees. They use this phrase, from recruitment through retirement.

There are a handful of other companies that offer similar services. Many also happen to start with Pay. But from the user, the employer perspective, what differentiates Paycom from its competitors? Mary, if you are a user of Paycom, let's say that you administer human capital management solutions in your company, it's got a bit of a nifty edge over some other software services you can look at. For example, this company takes information from the background check of a potential employee all the way through employment. They happen to be one of the biggest background check companies in the U.S. It's part of their revenue stream. But from the beginning, Paycom decided that

it wanted to pull information forward so that businesses didn't have to keep reentering bits of information. Another interesting thing that they do is they develop most all of their services in-house. They love to develop software internally. If you're using their system, get a nice dashboard, you can move around quite easily from one part of the service to another, from the payroll administration to looking at benefits for your employees to tax filings, which happen to be automated. It's one of the great services they offer. They can automate that whole worrisome process of filing quarterly returns for your company through the software. I think that it attracts on the basis of usability for businesses that

are looking at it and functionality. We'll get a little bit into its automation creds in just a bit, but those are the major reasons that attract users to the platform. From an investor perspective, one of the things that sticks out when I look at Paycom are its gross margins. They've been hovering at about 84% since 2016. That's higher than a lot of its competitors like ADP, Oracle, Paychex, Paylocity. What's the story there? One of the things that you must do if you are in this business is to strike a balance between payroll administration and then offering all these other services that line up under that human capital management banner that you and I were both mentioning.

How employees can save for retirement, what types of benefits they're eligible for, working with wage garnishments, there's an innumerable amount of services that you have to offer. approach of big payroll providers like the ADPs and Paychex and the Oracles of the world has been to acquire smaller companies, parts and pieces, to be able to offer everything to the businesses that they deal with. But this becomes a little bit of a clunky exercise from a user interface experience. It also leads to, I think, a bit of a higher gross margin for Paycom since they develop everything, as I said before, internally. If you're not trying to buy smaller companies and then spend money to integrate the services and then spend money on the support when things

don't work out, you actually have a smoother sales to cost of revenue relationship. I think that leaves you more, or a bigger chunk, I should say, to then have your fixed costs run against, which leads to hopefully a better operating margin as well. there are all these different elements and segments of the solutions that Paycom offers. Are they all or nothing? Do companies have to buy into everything or are there certain segments that garner a lot of attention and traction and others that not so much? This is a great question. Paycom is a little different than most of the companies you'll look at, be they really big or just small entrance into the space and that their pricing is opaque. You can't go online and try to

Google up a chart of Paycom services versus ADPs. We don't have a very clear picture on exactly how the services are offered up. But what we do know is that Paycom wants to sell its customers everything in one place solution. That's the default, but they will offer businesses the ability to choose a la carte bits from their menu. You can go either route, but what they're going to try to do upfront is to say, look, in the single pane of Glass's single dashboard, you get all our features for X price. You teased out that automation piece. I feel like today you can't look a Paycom without catching wind of this thing called Betty. It's not a person, it's a service. Maybe let's start with what is Betty?

So, Betty is basically an app that allows an employee to enter his or her own information on benefits and also time during a payroll period. And this cuts down errors for the company that's running the payroll. This is a really great thing for companies because it's notoriously difficult to get a payroll right, especially when you have, let's say, a flux of employees coming and going for businesses that experience that. Payroll is really difficult, and it's a cost, it's a cost center. What Betty does is allows the data source, that's the employee to input the information. When you cut down those errors, you cut down the reruns of payroll. What we heard from Paycom last quarter is, yes, Betty is getting a little bit too good for its own

good because with this reduction in error, those are fewer extra payrolls run, so that actually cannibalizes a bit of revenue. Now, Chad Richeson, the CEO, has been pretty adamant his whole career that he wants the best outcomes for customers. He is willing to take a little bit less revenue if the user experience is better for the customer. He will sell them more value-added products down the line. I think we've got a really temporary blip here with the company. There's one other part of that puzzle that investors should pay attention to. There is a group that upsells services within this company. They have been growing year after year after year. Last year was the first year that they pulled back a little bit and said, instead of

trying to upsell, we're going to spend more time on client premises with customers, helping them get value for the products that they have. Richardson was a little concerned that they were doing too much upselling. That also hit the top line and the projections for this year. A little kink there, but I believe it's a blip in a longer-term story that looks pretty bright. Paycom's a software company. It's also profitable. It's also quickly growing. It also pays a dividend. All of this feels rare for a software company. And yet, in large part because of these cannibalization and worries connected to Betty that we talked about, the stock has slumped a lot after its latest earnings call, which happened in November of

last year. The stock's now trading at under 35X earnings, that's basically half of what it was in 2022, and it's down from over 180 in 2020. How are you thinking about valuation right now? Do you feel that this is just a massive buying opportunity that others are missing? I don't think it's massive. I think it is a buying opportunity, but investors who invest in the payroll industry, I think are looking for a few more things out of this company. No. 1, their customer service really isn't up to par. They spent so much time investing in really a seamless experience without integrating a bunch of third-party tools that they have under-invested in areas where their bigger

competitors have been really on the ball. One quick example, Paychex since 2018 has been using AI to invest in customer-facing bots so people can get quick answers when they have issues with their payrolls. To date, we don't see that out of this company. I think also there are a few other friction points because they are so let's do everything in-house. They don't have a great API or an API that I've seen that easily connects to benefit providers. There's this whole interchange between benefit providers that is a little easier with the bigger platforms that this company doesn't have. They need to work on that as well. Thirdly, I think people are wondering if there's another company which

builds something from the ground up as well, is this more of an idea or a competitive mode? Maybe you and I, if we're really technically skilled, could try to build something similar with the idea that let's get the data first off when someone comes through the door and let that follow them through the organization and also offer an app where they can put this information in and have these seamless payrolls. That itself isn't something that's unassailable, but for their bigger competitors, they really don't want to pull their customers out of their models that currently exist. It's really, really hard to tell a company, we're going to do something similar to this process you've heard about, but it'll take four weeks of implementation

and the payrolls will be manual during that time. This is one edge that Paycom has. It's really difficult to recreate it on an enterprise level. But I think investors are just weighing the puts and takes of this and saying, yeah, it's probably a buying opportunity, but it's not that the whole market has missed the story here. They see it realistically, I think. Chad Richardson is the CEO of Paycom. He founded the company in 1998, and again, remains the helm to this day. We love a founder-led company here. Do you have any particularly strong takes on Richeson, his vision, his leadership, or how he's executed that vision? Sure. Let's get the elephant out of the room first. Richeson has one of the most lucrative

pay packages in all of Wall Street. He got, I think, $200 million worth of stock incentives a few years ago that if Paycom stock performs, could be worth into the billions in a few years. It's gotten a lot of pushback from that. Now, on the other hand, what I like about him is he's performed. This is a company that's really outperformed since they've been public. As you point out, very cash flow positive. They are contemplating more share buybacks. they have initiated a dividend. I like Richeson's lean attitude towards running his business. He doesn't like debt, so they've paid down all their debt, I think, except for maybe $29 million. They like to generate the cash and then invest it. There's not a lot of waste in the organization.

He's been pretty good at inspiring his employees to go and fight against the bigger players by developing their own stuff. I think he's kept the R&D engineers very happy at Paycom. They like to innovate and I think they will continue to. I think in terms of vision, leadership, execution, he's got all that and the company has historically deserved the multiples, the rich multiples the market has given it. It's just with this bump, with Betty starting to look like it may be too good for its own stuff, you do have this crossroads for the business and the stock. But we'll see. We'll monitor it this year quarter by quarter. Maybe you and I can chat again later this year and see how they're doing. Yeah, we can do a check-in. And if things

don't go according to plan, then that side hustle that you mentioned of us starting our own version of Paycom sounds like a promising opportunity. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So don't buy or sell stocks based solely on what you hear. I'm Deidre Willard. Thanks for listening. We'll see you tomorrow.