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Bank OZK's charge-offs play into short thesis; stock set to suffer


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Bank OZK's charge-offs play into short thesis; stock set to suffer

Bank OZK had a rough third quarter, and it appears likely the company's stock — as well as the stocks of other banks — will suffer for it.

The company on Oct. 18 reported earnings that showed continued pressure on funding costs, but it was a blip in credit quality that seems set to grab the market's attention. The bank charged off two loans in the third quarter for a total of $45.5 million. While the charge-offs were not nearly enough to produce a loss for the bank — the bank actually reported a relatively robust 1.33% annualized return on average assets — the company's stock declined as much as 20% at one point in after-hours trading. And analysts expect other bank stocks to decline because of the Arkansas bank's earnings.

"I think this is going to drag small and mid-cap banks and anyone with commercial real estate and construction concentration," said Michael Rose, an analyst who covers the bank for Raymond James. "I think this definitely weighs on bank stocks because it posits the question: Who's next?"

In management comments released alongside the earnings report, executives said the credits were exceptions to a robust Real Estate Specialties Group, or RESG, portfolio. The RESG portfolio consists mostly of construction commercial real estate debt, a source of the bank's strong earnings performance but also the foundation of concerns that the bank was growing too quickly in a risky asset class. The bank noted that there was one other loan that had been watch-rated because its loan-to-value ratio was approaching 100%. "Other than these two substandard and one watch credit, the credit quality of the RESG portfolio is excellent," management said in comments.

"That very well might be true, but it's not going to matter for a while," said Stephen Scouten, an analyst with Sandler O'Neill. "At least temporarily, this validates everyone's concerns, and it validates the shorts."

The company's real estate lending has been the target of criticism by short sellers, including Carson Block's Muddy Waters Research, in the past several years. Skeptics of the stock have criticized the RESG portfolio for the extensive construction lending outside of the bank's main footprint. Loans in New York City and Miami have constituted a significant portion of the RESG portfolio.

All three of the loans with credit quality concerns were originated in 2008 or earlier, something that could pose a concern to investors as the bank has pitched the RESG portfolio as one of short duration, where the bank unloads credits after a few years. The market's concerns about whether these charge-offs spell troubles for others might be amplified by the fact that the two loans were in sectors that have attracted a lot of concern lately: retail shopping and homebuilding.

Rose downgraded the bank's stock to "market perform" from "strong buy" in an Oct. 19 note, writing that the charge-offs in the critical RESG portfolio "were a non-starter and a key [tenet] of our formerly positive thesis." Rose said the market has shown that it is clearly concerned about credit under the assumption that the economic cycle might be turning shortly.

Sandler O'Neill's Scouten also said banks were set for a rough Friday because of Bank OZK's charge-offs. "I think this will weigh on the group as a whole," he said.

On the other hand, the expected sell-off might be mitigated by interest from value investors. The bank was already trading cheap relative to future earnings, both Scouten and Rose said. But with shorts emboldened, the bank's robust earnings year-to-date and its potential to produce strong income over the next year might not matter all that much.

"The stock has traded like everybody knew this quarter was coming and now that it has come, the stock is going to trade even more off of sentiment," Scouten said.