OZK Bank Preferred Shares Now Yield 6.6%
In May, I thought that the preferred shares of Bank OZK (NASDAQ: OZK) were too cheap to ignore, as the preferred dividend yield had risen to around 6.4%. At current share price of $17.55 for preferred stock shares, trading with (NASDAQ: OZKAP) as a stock symbol, the return is approximately 6.6%. In this article, I will mainly focus on the sustainability of the preferred dividend yield and recommend that you read some of my old posts better understand the bank’s business model.
The bank performed well in the second quarter
Although I’m primarily interested in the bank’s preferred shares, as I only own those fixed income securities, it’s obviously important to check how the company is doing because, at the end of the day, the bank needs to be able to pay preferential dividends. Rising interest rates should help the bank increase its net interest margin, but inflation should also not be forgotten and an economic slowdown could weigh on the performance of the loan portfolio, with more loans entering the “overdue” phase.
Fortunately, the bank posted a very strong result in the second quarter, with its interest income increasing to $281.5 million, while interest expenses only reached $15.7 million. This resulted in net interest income of just over $265 million, up from $250 million in the first quarter of this year and $241 million in the second quarter of last year.
Net interest income remains very important for Bank OZK because the bank does not generate much income from its non-interest activities. As you can see above, Bank OZK reported only $26.3 million in non-interest income for the quarter, while total non-interest expense was $109. million for net non-interest expense of $83 million.
This resulted in pre-tax and pre-loan loss provision income of approximately $183 million, and because the bank recorded just over $7 million in provisions for credit losses, the reported pre-tax income was $183 million. just under $176 million, resulting in net income of $136.4 million. We still have to deduct preferred share dividends which totaled just over $4 million, resulting in net income of $132.4 million attributable to common shareholders.
This is already a good first step for preferred stocks, as preferred dividends require less than 3% of earnings to be fully covered. In other words, the preferred dividend coverage level exceeds 3,000%.
And looking at the balance sheet liabilities, it seems we shouldn’t worry too much about the level of asset coverage either. The bank has 14 million preferred shares outstanding for a total of $350 million. This means that of the $4.6 billion in equity, about $4.25 billion is less than those preferred shares. Or if looked at from the opposite perspective, the asset coverage level is above 1,300%.
There is a caveat though, Bank OZK’s balance sheet contains just over $666 million of goodwill and intangible assets, but even if you exclude them from the equation, the asset coverage ratio is still very robust.
The loan portfolio remains solid
The combination of a very good preferred dividend coverage ratio and a strong asset coverage ratio is good news for preferred stocks. But the asset coverage ratio also requires a strong loan portfolio. If suddenly half of the loan portfolio defaults on loans, then even preferred stocks will face tough times as OZK Bank will have to scramble to protect its capital cushion.
Fortunately, Bank OZK has a strong balance sheet. Of the $26 billion in assets, nearly $5 billion is held in cash and investment securities, so the level of liquidity is quite good. I am primarily interested in the $18.55 billion loan portfolio and in particular the relatively small amount of loan loss provisions.
Looking at the breakdown of the loan portfolio, it is clear that non-agricultural and non-residential loans as well as construction and development loans make up nearly two-thirds of the loan portfolio. Fortunately, the vast majority of these loans qualify as “successful” with just under $160 million in loans rated as “special mention” or “substandard”.
Even more important than classification is the low amount of overdue loans. As you can see below, just over $22.5 million of the $18.7 billion loan portfolio has been classified as past due, which is quite a strong performance and a decrease from to nearly $31.5 million by the end of 2021.
An additional $36 million in loans is currently classified as “unearned,” but this is also down from $44.3 million at the end of last year. And with an average loan-to-value ratio of 64% in the Real Estate Specialties group, OZK Bank should be able to avoid substantial haircuts on its loan portfolio, even on loans now classified as non-performing. This means that Bank OZK should continue its strong history of being one of the banks with the lowest charge-off ratios in the United States.
The increased net interest margin could improve the bank’s earnings profile, but perhaps OZK Bank will also need to increase its loan loss provisions, as I can imagine the current inflationary environment puts some borrowers in a difficult position. From an investment perspective, I continue to hold the preferred shares of OZK Bank, and given the strong preferred dividend coverage ratio and asset coverage ratio, I am more than happy to maintain my position. and I wouldn’t mind adding to that position the extra weakness.