Bank OZK: High NIM & Low Net Charge-Offs Is A Winning Formula (OZK)

(Editor Note: This article was originally submitted when OZK was trading below $43/share, but was subject to a delay in publication)

Investment Thesis

Bank OZK (NASDAQ:OZK) is a regional bank that has offices across seven U.S. states which specialize in construction related lending. Year to date the stock is down 14.85%, prompting me to take a look. Bank OZK is a bank that generates high net interest margins due to the additional risk that is taken as a result of being heavy into construction lending. The bank handles this risk well as they maintain discipline by keeping leverage low which by proxy helps keep net charge-offs low. Currently, I see OZK as a hold as I forecast an annual return of 13.9%, however if OZK were to drop 10-20% further I would likely change my stance to a buy. In the meantime, we will have to be patient to see if we get this opportunity.

Net Interest Margin

Bank OZK has a loan portfolio that is construction loan heavy through what they call their Real Estate Specialties Group (RESG). The RESG loans make up 65% of the portfolio. Bank OZK also engages in community banking, leasing, RV & marine lending and ABLG. As we can see below, we have seen Bank OZK’s loan portfolio become more diversified over time in an attempt to slightly reduce exposure to construction lending.

Typically, construction lending is riskier than traditional mortgage lending or commercial lending, therefore you would expect to see higher net interest margins but higher net charge-offs. A prudent construction lender would also reduce risk by limiting leverage which we will get to further in this article. As we can see Bank OZK had a median NIM over the last decade of 4.2%.

If we look at OZK’s ten-year median NIM in comparison to other regional U.S. banks we can see that State Street Corp (STT), Fifth Third Bancorp (FITB), and M&T Bank (MTB) all have a decade-long average net interest margin of 0.9%, 2.7%, and 2.9%, respectively. This puts OZK as having the highest decade-long median NIM. This is no surprise given that construction lending yields higher net interest margins in comparison to real estate lending or commercial lending.

Concerning the stability of OZK’s net interest margin, we can see that the standard deviation for the net interest margin is 0.00387, which ranks it as having a high NIM standard deviation compared to the other banks. Again, this isn’t a surprise due to the volatility associated with construction lending, hence making future net interest margins more difficult to forecast.

Net Charge-Off Ratio

Another fundamental metric for appraising the quality of the loan book is the net charge-off ratio. As evident from the graph below, over the previous ten years, OZK has reported its NCO ratio between the range of 0.30% and 0.00%. When we put this alongside the banking industry averages, Bank OZK’s net charge-off ratio has been really strong considering their construction loan heavy portfolio. In 2018 the NCO ratio got as high as 0.3%, while in 2022 the NCO ratio got as low as near 0% which demonstrates a lot of discipline shown by OZK’s management team. Over the last ten years, OZK has beaten the industry average for net charge-offs every year which I see as impressive considering the high NIM.

Upon contrasting OZK’s ten-year average net charge-off ratio against its peers, we can see that STT, FITB, and MTB each reports a ten-year median NCO ratio of 0.00%, 0.40%, and 0.20%, hence OZK is placed second as part of this examination. Therefore, given that Bank OZK primarily makes construction loans with higher NIMs and FITB and MTB mostly makes real estate loans and commercial loans with lower NIMs, it is really impressive that OZK has lower amounts of NCOs.

Leverage

Since OZK engages in construction lending, it is important that leverage is well managed due to the higher associated risk. Bank OZK has consistently held a decade-long median asset to equity ratio of 6.2, where between 2015 and the past year, OZK’s assets to equity ratio was very consistent, ranging between 5 and 7. Overall, this is quite low for the average bank, however due to the high NIM from the riskier construction heavy loan portfolio, I see it as necessary to manage net charge offs. Bank OZK could increase the leverage to drive even better returns, however we must note that if a recessionary scenario were to play out where construction companies begin to struggle, this would be a problem for Bank OZK as some of their loans may not get repaid. This could lead to trouble for OZK as this could spike NCOs.

As expected, compared to its peers, OZK has the lowest amount of leverage which again is a good move by OZK’s management team as it is the conservative way to manage a construction heavy loan portfolio.

Efficiency Ratio

Bank OZK through the last ten years have run their bank very efficiently, where their efficiency ratio was far superior to industry averages in all of the last ten years. The efficiency ratio for OZK in an average year is in the high 30% range as you can see below, meaning that OZK manages overhead expenses very well. I believe this stems from the operations of the bank being quite simple which allows for a narrow focus on construction lending that then allows the bank to operate efficiently. This shows that the bank’s management team has done an excellent job in minimizing overhead expenses that would otherwise eat into net profit margins.

When comparing OZK’s decade-long median efficiency ratio against those of its peers, we can notice that STT, FITB, and MTB each exhibit a ten-year median net charge-off ratio of 73%, 58%, and 57%, hence OZK is ranked the best among its counterparts. From my perspective, this shows that OZK’s narrow focus allows them to keep costs down, therefore leading to less spent on overheads.

Deposits and Funding Sources

A key indicator that I like to observe is the loan to deposit ratio, where ideally the loan to deposit ratio should be under 100% as this indicates that the bank has enough deposits to meet the demand for loans at the bank. Concerning Bank OZK, I would say the deposit side of the business is not quite as strong as the lending side of the business. While the deposit side of the business is not weak, each year the loan to deposit is very close to that 100% mark leaving the business very little amounts of breathing room should loans grow unexpectedly fast or if deposits were to drop. This would leave the bank needing more expensive external funding. However, currently the bank has not required external funding for 9 out of the last 10 years, therefore the deposit side of the business is not inherently a problem. However, investors should keep an eye on it.

Valuation

When assessing the valuation for Bank OZK, I have decided to apply the following conditions:

• A normalized return on assets of 2.1% which constitutes the ten-year median spanning various market conditions.
• A normalized assets to equity ratio of 6.2 constituting the ten-year median assets to equity ratio.
• A normalized ten-year median payout ratio of 26%.
• A current price to book ratio of 1.00 and a future five-year expected price to book ratio of 1.04 which is calculated using the five-year median.

As shown previously, I project that Bank OZK across the next five years will deliver to shareholders a CAGR of 13.9% of which 9.7% is projected to stem from book value growth, 0.8% is expected from multiple expansion and 3.4% from an annual dividend. Hence, I think that Bank OZK merits a Hold rating based on the current share price of $42.36.

Conclusion

OZK is a well-managed bank with strong fundamentals particularly on the lending side of the business. The bank has very strong net interest margins largely due to the construction lending that makes up most of the OZK’s loan book. What is most impressive however is low the management team has maintained low net charge off ratios despite dealing with loans that are riskier in nature compared to regular commercial or real estate lending. I believe the low net charge off ratios shown through the years is in direct relation to the low leverage OZK have kept on the balance sheet. The narrow focus on construction loans has also kept the bank’s operations quite lean which is evident by a strong efficiency ratio. Based on my valuation, I see OZK as a hold due to an expected return of 13.9%. While this kind of return would constitute a ‘buy’ for some investors, I would prefer to enter this one at 10-20% lower than the current stock price. For now, I will wait.