How to value opportunity is a question with no easy answer, but it’s a relevant question to ask when it comes to Byline Bancorp (BY). This Chicago-based business lender has an attractive market opportunity lending to small and medium-sized businesses in the third-largest metro area in the country, not to mention taking share in what is still a very fragmented market. What’s more than fragmented market creates acquisition value for Byline, as well as M&A growth opportunity within the market.
So, the question is how much credit to give to M&A growth potential and / or how much of an M&A backstop to build in here. On its own, if Byline hits my core earnings growth targets, the shares aren’t all that attractive today, but I would be surprised to be looking at this bank again in a couple of years and not see either meaningful M&A to grow the bank or an acquisition of the bank.
A Solid Small Commercial Lender
Byline’s bread-and-butter is lending to the over 10,000 Chicago-area businesses with around $ 10M to $ 50M in annual revenue.
Unlike a lot of lenders of this size, Byline is not particularly leveraged to commercial real estate lending (around 37% of the current loan book), and likely at least some of that stems from the fact that bad CRE lending over a decade ago played a role in the bank having to be recapitalized and essentially reborn as Byline.
Instead, core commercial & industrial lending is a solid 35% of the loan book, and the bank also has a growing leasing business that makes up a little less than 10% of total loans. Byline is also a very active SBA lender, one of the 10 most active in the country, and the leading lender in its Illinois and Wisconsin footprint. The sale of SBA loans contributes significantly to the bank’s non-interest income (two-thirds of Q4’21 non-interest income), though about 15% of the bank’s loan book is made up of retained SBA loans.
Since recapitalization, Byline has generated above-peer net interest margin, a byproduct of the lending markets it targets, and below-average funding costs. The bank’s efficiency ratio is not exceptional, and bad debts as a percentage of loans and bank-owned real estate are a little higher than average (part of the “cost” of above-average loan yields).
Near-Term Lending And Rate Opportunities
Runoff from Paycheck Protection Program loans will pressure reported loan growth figures in 2022, but Byline did exit the quarter with around 6% quarter-over-quarter adjusted loan growth, including growth in both C&I and CRE lending. Byline’s commercial line utilization is already higher than most banks (over 53%), but loan demand is growing across its markets and I’m expecting loan growth in the mid-to-high single digits for the next couple of years.
Byline is pretty middle-of-the-road when it comes to rate sensitivity, with the bank estimating a 5% move in net interest income on a 100bp move in rates. The bank’s loan / deposit ratio is a little high at 85%, and although close to 60% of the bank’s loan book is variable / floating rate, existing rate floors mean that it will take about one or two rate hikes for Byline to really benefit from higher rates.
On a more positive note, while Byline’s historical deposit beta has been relatively high next to peers (close to 40% in the last cycle), there’s been significant progress in the deposit base since then, with the bank seeing non-interest-bearing deposits grow from 28% at the start of the last tightening cycle to 42% in the fourth quarter of 2021.
M&A – Buy Until You Get Bought?
More than one CEO of a small bank has made comments to the effect of that in banking, you’re a buyer until you get bought. Given the nature of the Chicago market, I do not think Byline will lack for targets – there are over 15 banks in the Chicago area with $ 1B to $ 2B in assets and no meaningful operations outside of Chicago, and there are likewise several credible targets if management wanted to acquire its way into Milwaukee.
With around 1% share in the Chicago metro area and an established presence in SBA lending, Byline should also hold appeal for a bank looking to acquire its way into the Chicago market, or looking to build on a small initial position in the market, particularly given cross-selling opportunities to that small / medium-sized commercial loan market.
Between PPP runoff and more normalized loan sale opportunities, I’m not expecting 2022 to be the best year for Byline in terms of pre-provision growth potential, but I do expect acceleration to double-digit growth in 2023. Management is also laying the groundwork for better operating leverage, continuing a branch-reduction program (six additional closures) that will see the bank go from 87 branches at the end of 2014 to 38 branches by mid-2022.
I’m expecting loan demand growth, higher rates, and share gains to help fuel above-average earnings growth, with Byline generating around 7% long-term normalized core earnings growth. I do believe the real number will likely be higher, as I expect management to look for acquisition opportunities, but I do not see Byline as a bank where growth-by-acquisition is core to the strategy. With a CET1 ratio of 11.4%, the bank is arguably overcapitalized as is, depressing near-term returns, but giving the bank options to pursue M&A.
Discounting those core earnings back, I get a prospective total annualized return in the high single-digits, and I typically insist on double-digit returns for a bank of this size. Likewise, neither ROTCE-driven P / TBV nor P / E (13x ’23 EPS, with a higher P / E to reflect scarcity value) suggests the shares are significantly undervalued today.
The Bottom Line
I do believe that it’s more likely than not that Byline will make another acquisition at some point in the next year or two, and that likely means that my current earnings expectations are too low. I also believe that there is also an M&A backstop here – if the valuation were to get too low, I expect a buyer would move in. As is, though, while I like the Byline story well enough, I do not see enough upside today to argue for choosing this bank over other options in the small bank space.