Four months have passed since I published my first Stock Pitch. In light of continuous interest rate hikes and rampant inflation, there were no real bargains to exploit. Hence nothing to pitch at all. That changed last week: Silicon Valley's venture capital provider, SVB Financial Group, hit rock bottom thanks to its uncertain short-term business outlook and a dry spell in VC funding. Still, I believe the bank's stock retreated too much, given the future private market growth opportunity and its hedge to benefit from increased income from interest-bearing accounts. Today's pitch is all about catching the ride when pessimism fares highest.
Update: On March 10, 2023 Silicon Valley Bank (SVB) filed for Chapter 11 bankruptcy protection following a bank run, making it the largest bank failure since the 2008 financial crisis. The collapse was triggered by a sudden surge of deposit withdrawals amid the Federal Reserve's aggressive interest rate hikes, which impacted the startup sector and consequently a significant part of SVB's clientele. The U.S. government stepped in to protect customer deposits, while HSBC acquired SVB's U.K. portion. Hence, the following article was a stock pitch gone terribly wrong. Still, I keep it on my blog to remind readers (and myself) that you live, and learn.
Long SIVB
SVB Financial Group (NASDAQ: SIVB) has lost 70% of its stock value since it hit an all-time high a year ago. The correction fits a broader market narrative: stay out, be patient. Despite this sentiment, SVB Financial Group managed a smooth 13.22% Return on Equity last quarter while setting the stage to be at the forefront of a rapid growth opportunity in the private capital market, with Morgan Stanley (NYSE: MS) predicting a compound annual growth rate of 12% over the next five years. Such a development would almost double the size of today's market by 2027.
Besides the growth of alternative asset classes, the bank's hedge on climbing interest rates by augmented client-fee income, and a recession-proofed leadership make SVB Financial Group a welcome addition to any portfolio in an uncertain world. Today’s market opening price of $230.10 for SIVB provides an opportunity. My current SIVB price target for the coming 12 months lies between $292 (base case) and $327 (bull case), see valuation for more details, which would result in a year-over-year upside between 27%, and 45% respectively.
Company Background
The founders of the Silicon Valley Bank hardly imagined that their company, launched over a game of poker, would grow into the size it is today. Bear in mind in 1983, the Valley was just beginning to pick up steam, and firms such as Apple (NASDAQ: AAPL) and Microsoft (NASDAQ: MSFT) were for less than a decade in business. The SVB started by collecting deposits from VC-Funded Businesses. As their clients grew, SVB extended its services to include later-stage funding, exits (IPO), and commercial banking for large public and private companies. In 1988 SVB went public on its own. Besides providing banking to VCs and their portfolio companies, SVB started its own Private Equity and Venture Capital division, becoming early investors of Cisco Systems (NASDAQ: CSCO) and Bay Networks among others. The bank has helped fund over 35’000 startups since its inception. In 2011 the SVB Financial Group came under the leadership of Greg Becker. The experienced banker has been with the firm since 1993 and thus gained first-hand experience during the dot-com crash, the Great Recession, and later on the Covid-19 pandemic.
As a holistic funding and financial service provider, with a 40-year-long track record, SVB offers a unique ecosystem for innovation and technology companies. Since Greg took over the bank’s leadership, it outpaced the growth rate of competitor banks, joined the S&P 500 in 2018, and enjoys an excellent reputation amongst its employees for its stance on diversity and inclusion. Nearly half of all US venture-backed technology and life science companies are clients of SVB, as well as 55% of all US venture-backed technology and healthcare IPOs were clients of the bank. Famous commercial banking customers include Shopify (NYSE: SHOP), Andreessen Horowitz, and CrowdStrike (NASDAQ: CRWD) among others.
Today SVB is the 14th largest bank in the US (AUM: $214 billion) and consists of four main businesses: Commercial banking, fund management, private banking and wealth management, and investment banking. At its core SVB still deploys capital to venture capital and private equity firms, which then finance startups and other firms. It also runs a VC/PE division which sometimes invests in SVB's already existing commercial client base, takes deposits, and writes up loans. The Silicon Valley Bank has a 25.9% market share in the Valley, crowning it market leader. Currently SVB Financial Group has 29 offices across North America, Europe, and Asia with further expansion ambitions.
Investment Thesis
Today there are mainly three key drivers which make SVB Financial Group an attractive entry opportunity at its current valuation:
Inflation Hedge & Liquidity Flexibility
Rampant inflation led to back-to-back interest hikes in almost all major economies (never mind Turkey). This development ushered in continuous market volatility and uncertainty. Yet, banks also profited: Higher interest rates meant higher interest earnings on borrowings. Good for banks, less so for businesses with a high cash-burn rate such as VC/PE-funded growth firms. SVB Financial Group currently sits at the intersection where interest-bearing income has substantially increased in comparison to last year, while its exposure to asset sensitivity is significant. Despite more expensive financing for its clients and increased write-down risk, SVB continues to see benefits on its interest-bearing accounts, and thus works as a hedge against further pressures on its asset side.
As a bank, SVB has access to significant off-balance sheet assets. $195 billion to be exact. This liquidity allows SVB an immense capability to borrow capital. The spread on interest rates keeps on improving, making it increasingly profitable to bring more assets on the balance sheet and redeploy them at a profit. Hence income from client investment fees will grow. By the end of September this year interest-bearing income amounted to $3.4 billion in comparison $2.2 billion in September last year. Off-balance sheet capital can also be used to bridge the gap for its clients between available VC funding and cash burn. Currently, total borrowing amounts to $10 billion per quarter. Eventually, when VC funding and cash burn-rate come back into balance, the SVB has the flexibility to bring funding costs down for its clients by means of refinancing and moving assets again off balance.
Growing Client Base
Due to prolonged volatility and market uncertainty private fundraising was pushed down by 40% QoQ and 54% YoY in comparison to a record-breaking VC funding year in 2021. Valuations in public, as well as private markets are taking a hit. Meanwhile, SVB’s loan growth has significantly picked up pace (see above paragraph) as firms turn to other means of financing. In the past quarter a record-breaking 1’800 companies became SVB commercial clients. A trend that indicates future business growth opportunities, as well as cementing the bank's current position in the private capital market. Clients are recognizing the flexibility of SVB's diversified financing options. While other banks retreat from the innovation sector, SVB is strengthening its position.
Nonetheless, net-deposit reduction due to the imbalance between VC funding and the cash-burn rate remains a decisive factor for future viability (see Risks).
Diversified VC/PE Exposure
Average investors don't get access to VCs or later-stage PE rounds. Why? Due to investor-protection regulation, the high-risk/high-return asset class is only available to qualified professional investors and high-net-worth individuals. Anyone fortunate to deploy capital in this sector, needs two essential attributes besides liquidity: Sound risk management and a lot of time. The average holding duration of VC/PE investments range from 5 to 10 years depending on the funding stage of the company. As of today, the sentiment for private fundraising is low. Most VC/PE firms retreated into a defensive financial positioning, stacking their cash and waiting it out. Presently, all private market players combined have about $2.5 trillion of unspent cash, waiting for the opportune moment. SVB Financial Group is positioned to profit massively when the floodgates open again, and the broader private market resumes its activity. As a SVB shareholder, the average investor can get broader exposure in the rather elusive VC/PE market while still profiting from a well-diversified allocation of capital within SVB Financial Group itself.
Valuation
Comparing the valuation of SVB's industry peers shows that SVB Financial Group's share price has historically traded at a premium to banks and more in line with other private equity behemoths. Today its P/E ratio trades at the large discount in comparison to the 5Y Mean. The base-case scenario indicates a reduction of the P/E gap to 15 which subsequently gives the current share price an upside of 27%. In a more bullish scenario, if the gap would be closed altogether by matching the P/E Mean of 17, the current share price has an upside potential of 45%.
A return to the record valuations of 2021 (P/E north of 25) are in light of forecasted developments for 2023 not realistic. Other factors to bear in mind for potential investors is the higher Beta ratio indicating that SVB's stock fluctuates more in direct comparison with industry peers. Risk-adverse investors should thus brace themselves. On a last note for value investors with regards to SVB Financial Group's valuation: The book value per common share sits at $200.71, giving the market share price a premium of only $30.
Valuation Comparison with Industry Peers
* Bank.
** Private Equity Firm.
Risk Factors & Mitigation Measures
SVB Financial Group faces certain risks which could lead to a further devaluation of its share price. The main risk factors include prolonged cash-burn rate of its clients as well as higher-than-expected peak interest rate in 2023.
Protracted Cash-Burn Rate SVB’s Achilles’ heel is the high cash-burn rate of its clients and the deposit depletion in line with reduced private fundraising to make up the difference. Markets want certainty and clarity which recently is hard to come by. During the earnings call last week, CEO Greg Becker reiterated that its clients are in the process of cutting the cash burn-rate. However the measure suffers from a lag, which reduces visibility: It takes time to spend VC money as well as decrease expenditure when needed. SVB’s leadership nevertheless expects to see a rapid improvement in the coming two quarters. If this wouldn't be the case, it could severely pressure the share price and increase uncertainty across SVB's business segments.
Peak Interest Rate Economists are disagreeing whether interest rates will peak at around 4.5% by mid-2023 or whether the suffering will continue. The latter scenario poses significant risks to SVB Financial Group. Besides severely affecting the costs of financing of its client base due to slower deployment of venture capital, such a scenario would also mean a profit reduction in other business segments of the company such as: Private investment, exit activity, and market-related gains. The bank itself would profit from its inflation hedge, thus limiting losses on the valuation of its holdings in the course of write-downs. Nevertheless a higher peak interest rate would hurt the stock price in the medium-term, making the base- and bull-case of this stock pitch redundant.
Consequently, to reduce risks in your portfolio, consider investing over the following three to four quarters (Dollar-Cost-Averaging) and observe how macro-economic factors unfold.
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The author owned shares of SVB Financial Group on the publication date of this article. For more information please see our disclosure policy & portfolio tracker.
Invest at own risk.
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