Hi all,
I finally got around to completing my review of Square 1 (SQBK). I could continue to spend more time on it but needed to put a stop at some point, so here it is. Have a look, and let’s talk about it if there is interest or if there are questions.
And yes, I should caution that while I have tried to be as accurate and factual as possible, I can’t guarantee against errors. Use your eagle eyes and judgement!
Cheers,
Anirban
Overview
Ticker: SQBK
Stock price (6/14/14): $19.03
TTM EPS: $1.10
Book value per share: $9.29
Diluted share count: 29,082,000
Market Cap: $553M
P/E = 17.3
P/B = 2.05
Square 1 Bank is a financial services company headquartered in the greater Research Triangle Park area in North Carolina. Square 1 Financial is the bank holding company for Square 1 Bank. Square 1 Bank offers a full range of banking and financial products and services throughout the United States, focused on the entrepreneurial community and venture capital and private equity firms. As of Q1 2014, Square 1 is a $2.5B holding bank with total loans of $1.1B and total deposits of $2.2B. It has 239 employees. Square 1 went public in March 2014 (and Q1 2014 was the first quarter in public eye).
Competition. Silicon Valley Bank (SIVB) is the other pure play, and it is much larger than Square 1 with operations worldwide. Other competitors include First Republic Bank (FRC), Comerica (CMA), Bridge Bank (BBNK), and City National Bank (CYN).
An Overview of Square 1 Financial’s Venture Banking Model
A quick overview of Square 1 Financial’s business model is useful for understanding both the company and the venture banking industry. Most of the information below is from Square 1’s 2013 Annual Report, which I thought was very well written and well-written such that non-banking folks can get a sense of their business model.
Square 1 actively solicits business from entrepreneurial companies in the technology and life sciences segments, and also from the venture capital firms that fund such companies. To these clients (i.e., startups + venture firms seeding startups), it offers commercial banking services such as traditional commercial loans, revolving lines of credit, equipment loans, asset-based loans, credit cards and capital call loans.
The terms of the credit facilities provided to clients depend on the type of loan product, loan size, startup’s growth stage, and underlying collateral. For instance, Square 1 provides term loans and lines of credit to venture-backed companies in the technology and life sciences sectors, with loan terms ranging from 12 to 48 months. The loan portfolio is diversified across sectors and life cycle of the startups. Additionally, the strength of the venture firm backing the startups is also considered when making loans.
For early stage startups (i.e., these don’t yet have income), repayment is through the venture investment round held in deposit accounts with Square 1. The commercial loans are generally secured by the borrower’s corporate assets (e.g., accounts receivable, inventory, equipment, and intellectual property) and may also include personal guarantees. Asset-based loans are typically given to late stage companies and are structured as revolving line of credit with advances based on a formula tied to accounts receivable or other assets. Repayment for early stage companies is typically through a new round of venture investments, while for late stage companies may include operating cash flow. As of December 31, 2013, the ratio of total deposits to loan commitments for early, expansion and late stage companies to which Square 1 was lending was 320.8%, 83.8% and 72.9%, respectively. (Note: Square 1 requires borrowers to maintain certain amount of liquidity.)
Square 1 also provides secured/unsecured capital call lines and lines of credit to venture capital and private equity firms. These firms use bank debt to smooth cash flow between transactions.
The venture banking model typically doesn’t use conventional retail sources of funding. Deposits come from venture firms and venture backed startups which are also the borrowers, and these typically maintain significant cash balances on deposit with Square 1. Of course, the deposits and loans are subject to volatility depending on the level of innovation/IPO activity, and thus there is a significant link to the general economy and its outlook. At times, the deposits will significantly outweigh the loans. Square 1 maintains an investment portfolio to manage deposits. Square 1’s stated policy is to invest in securities that are government guaranteed, agency-backed or rated investment grade (e.g., government agency securities, government guaranteed mortgage-backed securities, highly rated corporate bonds, SBA pools, municipal securities and other asset-backed securities.) In order to meet unforeseen liquidity requirements, the majority of the investment portfolio is considered “available for sale”.
Deposits
Banks use deposits to give out loans. The difference on the interest received on the loans and the interests paid on deposits is one of the ways in which a bank generates earning. The table below gives the total deposits at December 31, 2011, 2012, and 2013.
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2011 2012 2013
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Deposit(M) $1,508 $1,519 $2,106
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Unlike traditional banks, here the end of period deposit composition may be subject to year end activity of their clients (e.g., activity of ‘venture firms’). Looking at the deposit breakdown for 2013, we find that 65.5% is in non-interest bearing demand deposits, while the remainder is in some form of interest bearing deposit. About 28.3% is in money market, about 1.3% in time deposits, and 4.9% is in interest bearing demand deposits (a new product). The following note in the 2013 Annual Report summarises these movements:
Our deposits increased to $2.1 billion at December 31, 2013, from $1.5 billion at December 31, 2012, an increase of $587.4 million, or 38.7%. This increase was primarily due to growth of our client base and an increase in deposits due to our introduction of an interest-bearing demand account. While our noninterest-bearing deposits increased $318.8 million, or 30.0%, during this period, our interest-bearing deposits increased $268.6 million, or 58.6% during this same period.
Since year-end deposits may show fluctuations, Square 1 also provides some data on ‘average deposits’. The following table outlines the trends for the average deposits:
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2009 2010 2011 2012 2013
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Deposits(M) $1,080 $1,162 $1,409 $1,531 $1,871
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The average deposits show a healthy CAGR of 18%.
Loan Portfolio
Loan portfolio at 31 December of the past three years has been:
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2009 2010 2011 2012 2013
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Total loans (M) $485 $492 $715 $867 $1087
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Since 2009, the average loan has grown at about 25% CAGR. As of Q1 2014, the loan portfolio consists of about 85% venture banking loans, 9% venture firm loans, 5% USBA/USDA loans, and 1% credit card. The software sector accounted for the most loans (16.5%), followed by loans in the health care services, IT service, consumer products & services, biotech, medical devices, and financial services sectors (each account between 5 and 6%). The loans are also diversified by the state of the companies and geography. As of Q1 2014, 94% of the existing loans are variable rate.
Credit quality appears to be good. Non-performing loans as a percentage of total loans has been around the 1.5% mark since 2009. Net charge offs as a percentage of average outstanding loans has steadily decreased.
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2009 2010 2011 2012 2013
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Net-charge offs 1.94% 1.14% 0.79% 0.95% 0.95%
Non-perf loans 1.47% 1.13% 0.99% 1.68% 1.34%
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Net Interest Income and Net Interest Margin
Net interest income is the difference between the income from interest-earning assets and the cost from interest-bearing liabilities. Net interest income depends upon the amount and mix of interest-earning assets and interest-bearing liabilities and the interest rates earned/payed. The yield earned on loans includes loan fees, which are primarily loan origination fees and loan documentation fees related to loan origination.
Net interest income and the net interest margin for year-end 2011, 2012, and 2013 are shown below:
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2011 2012 2013
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Net Interest Income $59.3M $68M $79.4M
Net Interest Margin 4.02% 4.14% 3.91%
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Some notes on net interest income and net interest margin (from the 2013 Annual Report):
For the year ended December 31, 2013, net interest income increased $11.5 million, or 16.9%, to $79.4 million compared to 2012. This increase was primarily driven by a $11.6 million, or 16.8%, increase in interest income. Our interest income increase primarily resulted from:
• a $7.4 million, or 14.6%, increase to $58.2 million in interest income on loans resulting from a 22.3% higher average balance, partially offset by a 43 basis point decrease in the yield earned. The 43 basis point decrease in the yield earned resulted from increased competitive pressure in the current low rate environment.
• a $4.7 million or 117.1%, increase to $8.8 million in interest income on nontaxable securities caused by a 114.5% higher average balance and a 6 basis point increase in the yield earned. The higher nontaxable securities balance and yield was primarily a result of our purchases of municipal securities.
Interest income was partially offset by interest expense of $1.3 million, which represented a $0.2 million, or 16.3%, increase from 2012. This increase was driven by the higher volume of our interest-bearing liabilities. 56.7% of our funding for the year ended December 31, 2013 came from noninterest-bearing deposits compared to 61.6% for the year ended December 31, 2012.
Our net interest margin declined to
3.91% from 4.14%. The primary reasons for the decrease were:
• a decline in yields on our newly originated loans in response to competitive pressures in the current low rate environment;
• an increase in premium amortization on securities as the amount of prepayments increased in the low rate environment; and
• interest-bearing deposits grew at a faster rate than our non-interest bearing deposits and did not experience a decline in rates. The decline in the net interest margin was partially offset by:
• our decision to invest a greater percentage of interest-earning assets in higher yielding municipal bonds.
Non-interest Income
In addition to earning spread income (i.e, spread on the cost of deposits versus the earnings on loans), banks also have fee related earnings. Square 1 earns via fees for services, gain on sale of loans, and warrants.
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2011 2012 2013
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Core banking income $9.4M $11.1M $13.3M
Total non-interest income $6.9M $15.6M $25.3M
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**Note: Total non-interest income being less than core banking income indicates significant loss on sale of securities and/or warrant loss.
Some notes from the Annual Report:
Core banking income represents recurring income from traditional banking services provided to our customers. Income from these fees increased $2.2 million, or 19.8%, primarily due to an increased customer base combined with increased service utilization by our customers. Service charges and fees represent fees earned on our deposit accounts and credit card fee income. For the year ended December 31, 2013, service charges and fees on deposit accounts were $4.1 million, with growth of $0.5 million, or 13.0%, and credit card income was $2.5 million, with growth of $0.4 million, or 17.8%. These increases for the year ended December 31, 2013, are consistent with new customer growth and increased penetration with our existing customers.
Foreign exchange fees are primarily transaction based fees earned from our customers for performing foreign currency-based transactions on their behalf. The increase of $1.1 million in foreign exchange fees reflects our expanding geographic footprint and the evolving needs of our client base. Warrant income includes income realized upon the exercise of a warrant and the sale of the underlying equity
security and the quarterly mark-to-market of our warrant portfolio. We experienced several material warrant gains during 2013. This income is volatile as it is largely dependent on liquidity events experienced by our clients.
For the year ended December 31, 2013, our other income was primarily comprised of income earned from our debt, venture capital and private equity fund investments portfolio, fees earned based upon contingent
customer success events such as completion of an initial public offering or business combination. The increase in other income during the year ended December 31, 2013, compared to the prior year was primarily the result of increased customer success fees and gains on our investments in our private equity investments portfolio. For the year ended December 31, 2013, noninterest income from customer success fees increased $1.4 million, or 119.8%, to $2.6 million from $1.2 million in the prior year. These fees are by their nature volatile and there is no assurance that such fees will remain at these levels or increase in the future. Our
investments in debt, venture capital and private equity funds totaled $4.1 million at December 31, 2013. These investments are primarily in funds for CRA credit, other non-CRA funds for relationship purposes and an investment in our own fund-of-funds, Square 1 Ventures. For the year ended December 31, 2013, non interest income from these investments was $1.1 million, an increase of $1.3 million from the $0.2 million loss recognized in 2012.
Efficiency Ratio
Efficiency ratio is basically a measure of a bank’s profitability. It is measured by dividing noninterest expense (i.e. salaries, marketing, etc.) by total revenue.
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2009 2010 2011 2012 2013
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Efficiency ratio 65.3% 73.5% 65.4% 60.7% 53.1%
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Dilution
SQBK IPO’ed in March 2014. As of the most recent 10-Q, the diluted share count is 29,082,000.From the most recent 10-Q:
On March 31, 2014, the Company sold a total of 3,125,000 shares of Class A common stock in our initial public offering at an initial public offering price of $18.00 and received net proceeds of $51.1 million after issuance costs. On April 1, 2014, the underwriters exercised in full the underwriters’ purchase option granted in connection with the initial public offering, at the initial public offering price of $18.00 , resulting in an additional 468,750 shares purchased from us for which we received $7.9 million in net proceeds on April 4, 2014.
Going forward, there will likely be capital raising events and dilutions. The table below shows the diluted share count since 2009 (data at 31 December of the respective year):
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2009 2010 2011 2012 2013
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Shares Out 10,675,500 16,514,246 20,200,227 21,136,770 23,859,448
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Valuation - Is SQBK a buy?
Let’s compare SQBK with SIVB (Silicon Valley Bank) and some of the other competitors based on trailing PE and PB ratios (data from Bloomberg):
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PE (TTM) PB (TTM) Market Cap
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SQBK 17.3 2.1 550M
SIVB 19.77 2.5 5.7B
CMA 16.26 1.3 9.1B
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In terms of valuation, SQBK is trading at a similar valuation to SIVB. Potentially, it is a bit cheaper when we think about the market cap of SQBK, which is 1/10th of SIVB. For some perspective on how SQBK could grow, we can look at the past performance of SIVB. Looking 10-years back (June 2004) SIVB was trading around $37. Now it is trading around $113 for about a 3x gain in 10-years. At the depth of the financial crisis, SIVB hit a nadir of $12.06, so shares are up around 10x since those dark days!
So should we buy SQBK? Management seems to be executing well (high asset quality, strong deposit growth, strong loan portfolio, solid net interest margin etc). Its a young company and it is growing So after all of that, where do we end up? SQBK is a pure play on venture-funded technology and life sciences space. Currently, there’s a lot of activity in this space (IPOs, startups etc) so in the immediate future SQBK should be able to grow. The venture banking space is large enough to support a number of players, so there should be ample space for both SQBK and SIVB. It could be argued that there’s opportunity for international expansion into Europe, Israel, India, and China; SIVB already has presence in these geographies. If SQBK continues to operate well, book value should grow and the earnings as well as book value multiples may expand. That would be the icing on the cake.
The danger here is that the business is strongly coupled with state of the US economy and more so the state of entrepreneurial activity. Any hint of recession and these venture banking pure plays will be hurt. Being an optimistic, however, my take is that we are just slowly getting out of recession so may be the next one is some ways out. Further looking at SIVB and extrapolating, it appears that if one holds SQBK long enough there’s a good chance of coming out smiling on the other side even if there was an economic downturn. And, entrepreneurial activity in the technology and life sciences space is going to continue and grow in the foreseeable future, so SQBK is operating in a nice space.
Conclusion
SQBK could be a good investment if someone buys with a 5 to 10 year time horizon. Its like a broad play on the next-generation of ‘rule breakers’ - where you invest on the bank is providing the financial means to some of the rule breakers of the future. I suppose I ‘m unsure about the potential growth opportunity - or should I say the ‘market opportunity’ of this play.
One final thing: If you listen to the Q1 conference call, you will discover that there were only two analysts on the call. The analysts were from the two firms that acted as the underwriters for their recent IPO: Keefe Bruyette & Woods Inc and Sandler O’Neill and Partners LP. In some ways, this is clearly under the radar. If the current strong performance continues and a more analysts start paying attention, this one could really take off!
References and Reading Material
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SQBK 2013 Annual Report to Shareholders
http://ir.square1financial.com/common/download/download.cfm?.. -
SQBK 10-Q (Q1 2014)
http://ir.square1financial.com/secfiling.cfm?filingID=132979… -
SQBK Q1 Earnings Release
http://ir.square1financial.com/common/download/download.cfm?.. -
http://news.investors.com/041514-697207-square-1-financial-v…