There are no sure things with any investment approach, but generally speaking bank stocks tend to outperform when the company behind them can sustainably generate multiyear revenue per share and tangible book value per share growth in the high single-digits, healthy ROE, and strong customer satisfaction scores (measured by metrics like J.D. Power’s Net Promoter Score).
Unfortunately, OceanFirst (NASDAQ:OCFC) struggles to hit any of those on a consistent basis, and it’s hard to argue for the company’s succeeding in its plan to disrupt Northeastern banking markets without improved metrics.
These shares are up about 17% since my last update, tracking the regional banking sector. Business went more or less as I expected in 2023, but a higher-for-longer rate cycle is putting pressure on the business as OceanFirst hasn’t been able to keep up with deposit costs. While I can argue for a fair value in the low-$20’s by at least some metrics, I’m concerned about the suboptimal ROE (below cost of equity) and it’s tough to recommend the shares without something clearly positive to hang a bullish thesis on beyond a generally better environment for bank stocks in 2025 and beyond.
Credit Risk Seems Well-Contained
One area where I’m not that concerned about OceanFirst is credit quality. Charge-offs are still basically minimal (there was an outlier in Q3’23 due to a large CRE loan), and while non-performing loan totals have been rising (up 19% qoq in the last quarter), the overall credit outlook is pretty sound.
More than 10% of the loan book is in office properties, which demands attention given the stress on commercial office properties, but very little of that is in central business districts, and a fair bit (28%) is in areas like medical offices where the pressures have not been nearly so intense – remote work isn’t really an option for medical professionals. While I doubt the reported 56% weighted average loan-to-value ratio will hold as properties are reappraised, debt service coverage still appears adequate even under stressed scenarios.
I wish the company provided more disclosure around how it has reserved for its office and multifamily loan books, but criticized loans are still low (1.7%) and OceanFirst has a solid track record where credit quality is concerned.
Spread Pressure Remains Significant
One of the less-positive ongoing parts of the OceanFirst story is the bank’s lack of a solid core deposit franchise to help support the business through challenging rate cycles.
Non-interest-bearing deposits still declined 19% year over year on an average balance basis in the first quarter (and another 6% sequentially), and 16% of deposits, OceanFirst is a fair bit below the mid-20%’s level I’d like to see. This isn’t unusual for a bank with OceanFirst’s business model, but it still creates funding challenges; deposit costs rose almost 150bp yoy to over 2.3% and the cumulative interest-bearing deposit beta of 48% is higher than I’d like (though there are banks with worse betas to be sure).
At the same time, OceanFirst has not seen quite the same uplift from loan yields, with an average realized loan yield of 5.46% in the first quarter and a cumulative loan beta of 32%. That negative spread has hit the bank hard, pushing net interest margins from the 3.6%-3.7% range before the rate hike cycle to 2.8% in the last two quarters.
There really isn’t a way to offset that. Non-interest income is a fairly trivial part of the business today (around 10% of revenue), again typical for this sort of bank, and while earning asset growth has been above average (up 3% yoy in the last quarter), it’s not enough to offset the spread pressure.
The good news is that I don’t think the pressures are going to get all that much worse. Deposit costs seem to be stabilizing and relatively soft loan demand means that the bank doesn’t have to pay up to fund loan growth. At the same time, loans are coming onto the books at attractive prices (7.6% for new originations in Q1’24 versus a 5.5% overall average yield), and that should drive healthy spreads in 2025/2026.
Where’s The “Special Sauce”?
The biggest issue I have with OceanFirst at this point is that it largely looks like just another small bank. That will be okay as the operating environment for banks starts to improve later this year, but it doesn’t really point the way to outsized returns for shareholders and the longer-term returns here are nothing special, with a negative 4.7% annualized five-year return (versus a little under 2% for regional banks) and a 5% annualized 10-year return (versus 6.2%).
Management has talked about disrupting markets like Baltimore, Boston, and Washington, DC, but banks like Pinnacle (PNFP) and SouthState (SSB) are targeting some of these same markets, and doing so with more arrows in their quiver (including higher Net Promoter Scores and significant competitive hire-aways from larger banks). While I do think there are meaningful opportunities for small commercial lending in the Northeast, particularly as banks like M&T Bank (MTB) and New York Community Bancorp (NYCB) get more careful on CRE lending, I’m just not seeing evidence in the numbers of OceanFirst doing something remarkably different than its peers.
The Outlook
After what could possibly be a double-digit decline in earnings for FY’24, I expect a sharp rebound in FY’25 and FY’26. A lot of this depends on the pace of Fed rate cuts and the health of the economy, with the former having a major influence on OceanFirst’s spread outlook and the latter having more influence on loan demand and credit quality.
I do expect around 4% to 5% long-term core earnings growth from OceanFirst (from 2023) or around 2% to 3% growth from the last pre-pandemic year (something of a normalized starting point). Those numbers compare to a historical 4% growth rate for tangible book per share and around 2% for revenue per share.
My biggest concern, frankly, is that OCFC has a poor track record of generating returns relative to its cost of capital. Estimating an equity cost of capital for OCFC involves a lot of assumptions, of course, but I’d say something in the 10%-12% is a good starting point and the bank hasn’t generated a double-digit ROE in the last decade. Even if you want to quibble about what the real cost of equity is, or should be, it’s certainly higher than the 7% trailing average ROE of the last five years.
I get to a high-teens fair value with a discounted core earnings approach, and this methodology definitely punishes ROEs below equity cost. It’s also not the only approach I use, as I also find ROTCE-driven P/TBV and P/E to be useful. If OceanFirst can generate a return on tangible common equity of around 10% over the next 12 months (it managed 9.4% in the last quarter), a multiple of almost 1.25x is supportable, driving a fair value in the low $20’s. Likewise, a forward multiple of 10.4x on ’25 earnings is below the long-term norms for the sector (mid-14’s) and still gets me to around $20.
The Bottom Line
Whenever rates fall, OceanFirst should be a beneficiary and that should get repriced into the shares. That could set the stock up for outperformance as investors factor in better spreads in the coming years, but I’m still leery of making this a recommended name. As I said, I just don’t see what is special here and there are other banks out there that offer leverage to the rate cycle and a few other positives, whether that’s in returns, growth drivers, or what have you.
