Attractive Valuation on Pure Play Venture Bank with Solid Capitalization, Strong Track Record and High Potential for Long-Term Success
Square 1 Financial Inc. (NASDAQ: SQBK) went public on March 27, 2014, at an offer price of $18 per share (above the $15 – $17 per share filing range). Through the IPO, Square 1 and selling shareholders (venture investors) sold 5,781,126 shares of Class A common stock (of which the company sold 3,125,000 shares and selling shareholders sold 2,656,126 shares).
Shares closed their first day of trading at $20.60 with a gain of 14.44%, giving the company a market capitalization of about $570 million.
Square 1 is the bank holding company for Square 1 Bank – a niche bank focused on serving the financing needs of entrepreneurial, private equity and venture-financed startups with lines of credit (backed by receivables and inventory), commercial loans and real estate loans through SBA and USDA loan programs. As of December 31, 2013, Square 1 had a loan portfolio of $1.1 billion, investment securities of $1.1 billion, total assets of $2.3 billion and total deposits of $2.1 billion.
IPO Values Square 1 at Significant Discount to Larger Competitors
At $18, Square 1 is priced at a price-to-earnings ratio of 19.1x and a price-to-book ratio of 2.2x, with a valuation that is significantly below the 26.9x P/E and 2.98x P/B of its larger competitor, Silicon Valley Bank (SIVB).
The company expects to raise net proceeds of about $52 million and will not receive any proceeds from shares sold by selling shareholders.
Square 1 is a pure play venture bank focused on serving innovative startups, with hundreds of new potential clients created each year. Square 1 has a strong focus on venture-backed companies, an extensive network within the VC and startup community that results in deal flow, and an experienced and seasoned management team that has a proven track record of funding structure-less startups with innovative financing.
Square 1 has grown its
loan portfolio at a compounded annual growth rate of 22% from 2009 to 2013, while growing deposits at 15% annually. Its diversified loan portfolio has borrowers across industry, stage, size and geography. Its deposits bear a very low average cost of 4 basis points.
Square 1 has strong profitability metrics with 1.06% return on average assets, net operating income growth of 52%, an efficiency ratio of 53%, and net interest margin that has consistently averaged above 2.9% from 2009 through 2013.
Square 1’s net operating income has grown at a 51% annual pace since 2010, to $36.1 million in 2013. 2013 also benefited from $3.8 million in warrant income. Growth was driven by new loans, deposits, and banking, treasury and investment advisory fees.
Barring a 2010 loss related to the sale and impairment of non-agency mortgage-backed securities purchased before 2008, Square 1 has consistently grown net income, with 57% net income growth to $22.1 million in 2013.
Square 1 is well diversified across technology and life sciences sub-sectors, with an average loan yield of 6.34%.
Sound Operating Strategy for Steady Growth and Expansion
Square 1 plans to expand by growing core low-cost deposits which fund loans disbursed by the company. Square 1 requires that banking clients maintain deposits with Square 1 Bank. However, startups have volatile capital needs, so the company carefully manages the risk volatility of its bank deposits. For new deal flow, Square 1 needs to leverage and build relationships and its reputation as a nurturing lender with venture bankers and the entrepreneurship community in key markets across the U.S.
From a revenue and risk perspective, Square 1 must balance loan portfolio growth with well-managed non-performing-loan risk for strong credit quality. Square 1 is focused on reducing its ratio of non-performing loans but this is an intrinsic business cost tied to the inherently higher risk of venture lending.
Square 1’s key differentiation is its focus on venture banking, with high-touch personalized banking that caters to entrepreneur motivations and the VC/PE community in a adaptive and flexible manner.
In addition to interest income from its loan portfolio, Square 1 is focused on expanding its non-interest income from fees for value-added transactions and services such as letters of credit. Non-interest fees and services brought in almost 25% of the company’s total revenue in FY 2013, and the company plans to increase revenue diversity.
Finally, Square 1 (through Square 1 Asset Management) invests funds (received as deposits) in excess of what it lends out, and prudently and conservatively manages investments to provide additional income without increasing risk.
Well Positioned For Rising Interest Rate Environment
As interest rates rise in the coming years (as Fed chair Janet Yellen recently suggested), Square 1’s profits should increase because 93% of its loans are at variable rates, with a short average duration of 2.8 years. A 100 basis point increase in interest rates would boost interest income by 2.5% in the first year (of higher rates) and by 8.3% in the second year. And a 300 basis point increase could boost net interest income by as much as 17.1% in the second year of higher rates. With rates set to inevitably rise, higher rates charged on variable rate loans should boost net interest income considerably.
Niche VC Bank with Well Managed Risk
Square 1 is a $2.3 billion bank holding company with a loans’ portfolio of $1.1 billion and total deposits of $2.1 billion (on balance sheet). The company was founded in 2005 by veteran venture bankers with strong expertise in understanding the needs, risks and mezzanine debt structures for venture-backed companies and their VC investors. Square 1 is headquartered in Durham, North Carolina, and has 11 additional offices in key innovation hubs such as Boston, San Diego and Silicon Valley, with plans to open additional offices in San Francisco and Chicago. Square 1 primarily serves early-stage venture-backed technology and life sciences companies.
Square 1’s business model is simple. It uses low cost deposits (0.04% on average) to finance loans to entrepreneurs and venture-backed companies, typically starting with early stage companies and building a cross-selling relationship with deposits, treasury and investment services through IPO or acquisition.
Square 1 has a strong focus on managing credit risk and a specialized credit infrastructure to effectively manage its lending portfolio. The company has solid capital ratios that reduce the bank’s risk of failure substantially.
Well Diversified Revenue with Multiple Non-Interest Income Sources
In addition to interest income from loans, Square 1 receives non-interest-income from multiple sources such as core banking services (53% from service charges, foreign exchange, letters of credit and client investments), other (24% from bank-owned life insurance, private equity grants and customer success fees), warrant income (15%) and gains from the sale of SBA loans (8%). Warrant income, however, is highly volatile and tied to successful client liquidity events. Square 1 currently has warrants on 451 client companies, and realized warrant gains on 31 companies in 2013. This diversification of income sources boosts the bottom-line but is also integral to winning deals.
IPO Details Show Relatively Less Dilution to New Shareholders
With a 15% overallotment option, underwriters – Sandler O’Neill and Keefe, Bruyette & Woods – have
the option to purchase up to 867,167 additional shares, of which up to 468,750 shares would be from the company and 398,417 shares would be from selling shareholders.
Square 1 plans to use net proceeds to support long-term growth by enhancing its capital ratios under Basel III rules for liquidity and decreased leverage, and for general corporate expenses. Square 1 Financial plans to redirect 90% of IPO net proceeds (about $41 million) to Square 1 Bank.
The company also plans to secondarily use net proceeds to redeem Series A preferred stock and retire indebtedness related to outstanding Trust Preferred Securities. However, the company’s preferred stock ($5 million) and trust preferred securities ($7.4 million) are convertible into common stock at a conversion price of $10, so the company expects virtually full conversion of preferred and trust preferred into common shares at the next redemption date, with minimal outlays for redemption.
The company has a pro forma net tangible book value of $8.57 per share so new shareholders will suffer dilution of $7.43 at the offering price of $16 per share. Post IPO, the company expects to have 27,200,336 shares outstanding (27,669,086 if underwriters fully exercise overallotment and 29,602,096 assuming all eligible securities convert to Class A common shares).
The company does not plan on paying dividends.
Strong VC Activity = Ample Venture Banking Opportunities
Venture capital is alive and well in the U.S., and has gained a fresh boost with the spate of highly successful technology and life sciences IPOs over the past few years. After a recession-related dip in 2008-2009, venture investments were back up to almost the 4,000 level in 2013, with a total of $29.4 billion in fresh capital. And of these, 77% were in Square 1’s sweet-spot with 53% in the technology sector and 24% in life sciences – virtually assuring the company of new potential opportunities every year.
Strong Low-Cost Source of Funds Drives Profits
Fully 52% of Square 1’s deposits are non-interest bearing, and that helps significantly bring down the company’s average cost of deposits, to just 0.04% in 2013. These low cost deposits are a key aspect of venture banking success and help drive net profit margins higher. In addition to about $2.1 billion in on-balance sheet deposits, the company had $557.9 million in off-balance sheet investment funds that are used to manage deposit growth and volatility through the company’s Square 1 Asset Management division which is a registered investment advisor.
Expenses to Rise in 2014 – To Finance Growth
Square 1 has significantly improved its efficiency ratio from a peak of 73% in 2010 down to 53% in 2013. However, investors should expect 20% higher expenses in 2014 as the bank updates its online banking platform, introduces new services and adds control and monitoring. The company also expects increased expenses as it recruits new bankers and adds offices in San Francisco and Chicago. The company also expects slightly higher expenses tied to the December 31, 2013, acquisition of Sand Hill Finance in Campbell, CA (near Silicon Valley).
Risks and Competition
Square 1 faces relatively few risks because it has a proven track record, is well capitalized and is run by industry veterans. Its primary challenge is winning deals against larger competitors Bridge Bank, Comerica, Silicon Valley Bank and First Republic Bank. Square 1 also competes with select debt funds and specialty finance companies. However, Square 1’s smaller size and willingness to do earlier stage debt financings will give it a leg-up over larger banks and their preference for larger deals.
The table below compares Square 1 with leading competitor Silicon Valley Bank (SVB). SVB is significantly ahead on assets, loans and deposits, and highlights Square 1’s potential growth opportunity. The table also highlights Square 1’s significantly stronger pace of loan and deposit growth, and higher returns on average assets (1.06% vs. 0.93% for SVB) and average equity (12.44% vs. 11.20% for SVB), and higher net interest margin (3.91% vs. 3.29% for SVB). And while Square 1 has higher non-performing loans, this reflects the bank’s willingness to finance younger firms. However, Square 1 is strongly focused on credit risk management so non-performing loans do not overwhelm the balance sheet.
Well Managed Risk Platform, Steadily Reducing NPLs
Square 1 monitors loan covenants and borrowers’ performance on a monthly basis, and has quarterly discussions on borrowers with venture firms. In parallel, the company is also focused on continuously improving its credit process controls platform. Clearly, risk mitigation efforts have paid off. As the charts below show (2009 through 2013), allowance for loan losses (as a percentage of total loans) is down to 1.7% from 2.05%, net charge-offs are down to 0.95% from 1.94%, and non performing loans are in a clear downward trend even though episodic spikes do occur. From an investor’s standpoint, Square 1’s active risk mitigation strategy is working and should reduce non-performing loans and charge-offs even further in the coming years.
Management Team – Highly Experienced in Venture Banking
Square 1’s management team includes industry veterans, each with 20+ years of relevant experience in technology and life sciences venture banking, finance and capital markets. Doug Bowers, President and CEO, has over 30 years of corporate and commercial banking experience. Patrick Oakes, EVP and CFO, was formerly the CFO of Encore Bancshares and has 20+ years of banking, finance and capital markets experience. Judith Erwin, founder, EVP and Chief Credit Officer, has 25+ years of technology and life sciences lending at prior positions with GE Life Sciences Finance and Hercules Technology Growth Capital. In addition, the company has banking heads in key innovation hubs.
Overall, the team brings a depth of experience and connections to the company. Square 1’s steady growth and profitability since its 2005 launch attest to management’s operational experience and network, and will drive strong post-IPO growth.
Consolidated Financials – Solid Income Growth, Stable Balance Sheet, Growing Cash Flow
Barring a loss in 2010 from losses on non-agency mortgage securities, Square 1 has consistently increased GAAP income to $32.4 million in 2013, a 50.2% increase over FY 2012 (and up 52.3% for non-GAAP operating income).
On a non-GAAP basis, the company had adjusted operating income of $105.3 million in 2013, up from $84.2 million in FY 2012.
Square 1 ended the quarter with cash of $105.7 million, net loans (disbursed) of $1.06 billion and total assets of $2.3 billion, with $2.1 billion in total deposits and borrowings of just $6.2 million. If underwriters exercise their overallotment option, Square 1 will have shareholders’ equity of $245 million.
Square 1 has consistently delivered positive operating cash flow, including $55.3 million in 2013 that was up 48% over FY 2012.
Square 1 has strong double-digit income growth metrics, is well capitalized, has steadily grown its loan portfolio since its founding in 2005, and has demonstrated three years of profitable operations with rising net income year-on-year. The company’s niche focus on venture banking and the high level of entrepreneurial activity in the U.S. creates sizable new client opportunities each year. Square 1’s focus on financing innovation (primarily in the fast growing technology and life sciences sectors) and personalized venture banking significantly differentiates it from large banks. Its smaller size gives it a leg-up over direct competitors such as Silicon Valley Bank.
Square 1 is valued at a significant discount to competitors. Overall, Square 1 offers an excellent opportunity to get into a niche well-capitalized and stable bank, run by seasoned veterans, and offers steady share price appreciation prospects and potential upside tied to warrants.