EUR 850.00 For Business Accounts Only

Morningstar | Silicon Valley Bank Surprisingly Sees Little Benefit From Higher Interest Rates

Though we’ve been bearish on no-moat Silicon Valley Bank for a while, even we were surprised to see only a 3-basis-point improvement in net interest margin and a 2-basis-point decline in loan yields during the quarter. The bull argument is that Silicon Valley Bank is one of the best-positioned banks to benefit from higher rates, given it's largely funded by non-interest-bearing deposits and mostly lends at floating rates. However, this quarter, the bank saw practically no benefit from higher rates. The decline in yields was driven by lower prepayment fees, which can make interest income choppy. That said, given rates are going up, we'd expect lower prepayment fees to continue. In the fourth quarter, we would expect improvement in NIM, as three-month Libor has already increased by nearly 8 basis points, which is larger than the entire increase seen in the third quarter.

In the third quarter, Silicon Valley Bank earned $5.10 per share, a 15% improvement from the previous quarter. Much of this improvement came from gains on warrants and lower credit provisions. We doubt provisions this low will continue, and with the potential adoption of a new accounting standard, Silicon Valley Bank will see higher provisions in 2019. We’ll be maintaining our fair value estimate of $98 per share for now. With book value per share of $92.48, our fair value is about 1.1 times book. Despite the recent drop in shares, we still think the bank is extremely overvalued and shares need to drop by more than 50% to reach our fair value.

The bank gave initial guidance for 2019 and expects loan growth in the midteens, modestly lower than 2018 growth, while noninterest expenses are expected to grow at midteens rates. It would appear that the bank is already accelerating its investment. During the quarter, full-time employees grew by 8% sequentially. During the previous 18 quarters, headcount grew no higher than 5.3%. Fee income excluding gains on warrants and securities per average employees was approximately $53,000. This is more than a 45% increase in fee income per employee. We’d argue that the bank is right to increase expenses and possibly wasn’t doing enough hiring to accommodate its recent growth.

During the quarter, Silicon Valley Bank also significantly increased its short-term borrowings. Management said this was “just short-term liquidity management.” We don’t understand why Silicon Valley Bank has to use short-term debt when it has no trouble attracting off-balance-sheet client funds. Total client funds grew 4.8% from the previous quarter, but on-balance-sheet deposits were slightly down from the previous quarter. Total loans grew by 5.8% from the previous quarter. Now, total loans stand at 57% of total on-balance-sheet deposits. Excluding the disruption of the 2008 financial crisis, not since 2006 have loans been this high relative to deposits at Silicon Valley Bank. In recent quarters, Silicon Valley Bank has said that growth in client funds has been fueled in part by sovereign wealth funds. Geopolitical tensions could have some impact on deposit growth.

For the third quarter, loans to private equity and venture capital funds were the biggest driver of loan growth, increasing 9.3% from the previous quarter. This loan segment now accounts for about half of Silicon Valley Bank's total loans. We’ll remind investors that these loans have lower yields, and the mix shift likely partly explains why Silicon Valley Bank hasn’t been able to achieve better net interest margins. Furthermore, it appears capital call lines to VC funds haven’t realized the full benefit from recent rate hikes, as management said that rates to private capital call lines have increased to the mid-4s, “the spread between VC and PE has narrowed a bit from the historical 50 basis points, to closer to 25 to 30.” In addition, loans to software companies have only grown 1.5% year to date. It does appear that competition is having an impact on loan growth and pricing, which management mentioned during the call.