Provident Financial Services, Inc.

Moat: 1/5

Understandability: 3/5

Balance Sheet Health: 4/5

Provident Financial Services, Inc. is a holding company for a community bank, primarily serving the New Jersey market with traditional banking services such as lending and deposit-taking.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview:

Provident Financial Services, Inc., operates primarily through Provident Bank, a New Jersey-based community bank. Its operations are focused on providing traditional banking services, including lending, deposit-taking, and other related services, primarily to individuals, small businesses, and commercial customers.

  • Revenue Distribution: PFS generates revenue primarily through two sources:
    • Net interest income: Earned from the difference between interest income on loans and interest expenses on deposits and other borrowings.
    • Non-interest income: Generated from sources such as service charges and fees, loan servicing fees, wealth management income, brokerage activity, and gains or losses on sale of assets, real estate and securities.
  • Trends in the Industry:
    • Increased regulatory compliance that requires constant investment in new tools and practices.
    • Increased competition, especially from online banks and fintech companies.
    • Fluctuations in interest rates and consumer confidence.
    • Shift in customer behaviors towards digitized financial products and services.
  • Margins: The bank reports net interest margin as interest revenue minus interest expenses divided by average interest-earning assets, which has been around 3% in the past few years. Profit margins can be unpredictable as they are mostly impacted by fluctuations in interest rates and market conditions.
    • For Q2 2024, the reported net interest margin was 3.26%, an increase from 3.21% in the same quarter of 2023. This increase was primarily driven by a higher yield on earning assets coupled with only a small increase in the cost of funds.
  • Competitive Landscape: Provident faces strong competition from larger national banks, online banking platforms, and local community banks. Its competitive position is reliant on its ability to offer tailored local banking services and building strong customer relationships within their local community.
    • The bank is increasing the use of technology and digital tools to meet the changing customer demand which will incur significant cost.
  • What Makes Provident Different:
    • Strong local focus: Provides personalized services tailored for the communities they serve in New Jersey, particularly in central and northern New Jersey and areas of New York.
    • Established presence: Has been operating for more than 180 years, building a strong local brand image among the community.
  • Strong focus on providing lending solutions to diverse markets: including business, consumer, and commercial real estate loans, offering a full suite of financial services in their local market.
  • Relationship-oriented approach: Focuses on establishing long-term relationships with their customers.

Financial Analysis:

  • Income Statement:
    • The company has recently focused on reducing interest expenses and increasing net interest income.
    • For the second quarter of 2024, the Company reported net income of $14.9 million, which included $6.1 million after taxes, or a decrease of 41% from same period in prior year. This was attributable to an increase in loan loss provisions, lower gains from asset sales, an increase in loan amortization, and a decrease in fee income, partially offset by the increase in net interest income.
    • For Q2 2024, the company posted a Net Interest Margin of 3.26%, compared to 3.21% in the same period prior year. This increase was due to a higher yield on earning assets offset by a slight increase in the cost of funds.
    • For the year ended December 31, 2023, the company reported Net Income of $17.6 million. This compares to the $116.1 Million reported for year ended 2022. The major contributors are a significant decrease in gain from sale of securities, and an increase in provision of credit losses for non-performing loans.
    • The main driver of net income is net interest income, which fluctuates based on the interest rate environment, making it difficult to forecast future profits.
  • Balance Sheet:
    • Provident has a relatively high percentage of loans compared to other assets, which could indicate greater exposure to credit-related losses.
    • The ratio of non-performing loans to total loans has increased from 0.57% on December 31, 2021, to 1.52% at December 31, 2022, and is continuing to rise, reaching 2.16% at September 30, 2023. The provision for credit losses also increased for the past few years.
    • The increase in total assets has increased from $12.48 billion at December 31, 2021, to $14.32 billion on December 31, 2022. For the quarter ended September 30, 2023, the total assets has decreased to $13.95 billion. This fluctuation in total assets could be attributable to an acquisition and subsequent changes.
    • The company’s debt has been increasing, and the tangible common equity ratio has decreased from 10.39% at the end of 2021 to 7.67% at the end of Q3 2023, indicating a higher level of debt for the equity of the company, implying risk. The company has set a goal to manage the debt to equity ratio between 7% and 8%.
  • The balance sheet is reasonably liquid, as indicated by a liquidity coverage ratio (LCR) of 130% at the end of September 2023, which is much above the minimum regulatory requirement of 100%.
  • Cash Flow:
    • There are large fluctuations in cash from operations. In 2022, cash provided by operating activities was $176.9 million compared to $64.4 million in 2021 and $831.1 million in 2020. For the 9-months of 2023, cash from operations decreased by approximately 50% from that same period prior year. These fluctuations are largely attributed to sales of investment securities and changes in derivative instruments, which may pose concerns for future performance.
    • Cash flow from investing activities has been fluctuating due to changes in held-to-maturity securities, as well as available for sale securities, that are susceptible to market conditions.
    • Cash flow from financing is mostly derived from short-term borrowing, and repurchasing and issuance of stocks.

Moat Assessment (1 / 5):

Provident Financial Services, Inc. has a very weak moat (1/5). Here’s the rationale:

  • Limited Pricing Power: As a community bank, PFS’s ability to differentiate itself is primarily based on service and relationships within the local communities. They are usually dependent on the rates being offered in the broader market, which offers limited pricing power against its competitors.
  • Intense Competition: The banking industry is intensely competitive, with low barriers to entry for new entrants, and established national and local players all vying for the same customer base. This makes it difficult for PFS to establish a unique position with long term advantages.
  • Lack of Scale: The company operates mostly in the state of New Jersey, not having nationwide presence compared to larger banks, which are able to achieve economies of scale.
  • No Network Effects: The company does not benefit from the network effects of larger national banks which often see more customers due to a larger presence. The presence of network effects is not that big of a factor in the local community banking space.
  • Limited Customer Lock-in: Switching costs are relatively low for most customers, as it’s easy to transfer to competing banks.
  • No Intangible Assets: PFS does not have considerable brand recognition or proprietary technology that may put it at advantage against competitors.

Overall, while they have a long history and community ties, this is not sufficient to construct a durable competitive advantage as the business operates in a very competitive market and with a relatively narrow geographical reach.

Risks to the Moat and Business Resilience:

  • Interest Rate Risk: Rising interest rates can make the deposits more expensive to the bank which could potentially erode margins, while making the loan rates higher which may cause lower demand for loans. Conversely, declining interest rates may lower the amount the bank receives from its loans while the cost of its deposit rates may not reduce at the same rate, squeezing profits.
  • Credit Risk: Default rates or the creditworthiness of borrowers may increase during economic downturns that are outside the control of the bank, affecting overall profitability of the bank.
  • Regulatory Risks: Changes in government regulations or policies can make it more expensive and difficult to operate the bank.
  • Economic Risks: Economic downturns or inflation could affect the financial health of the bank’s customers, causing higher loan defaults, and lower growth in the local economy.
  • Technological Disruption: Failure to keep pace with digital transformation, and changing customer preferences could cause losses for the company.

  • Competition: As described previously, intense competition with other players with greater resources can cause losses for the company.

  • Business Resilience: The company has historically maintained a consistent balance between loans and deposits, with good reserve funds to offset loan losses. Also, the business model is largely concentrated in the local New Jersey market with local community support. However, the cyclicality in bank earnings due to interest rates makes the business vulnerable to unexpected changes.

Understandability (3 / 5):

PFS’s business model is of moderate complexity (3/5). The basic operations of the company as a commercial bank are easy to understand, such as lending and borrowing, but the risk in financial statements is difficult to gauge for lay investors. Also, the numerous complexities due to regulations and changing interest rate environment pose a challenge in assessing the stability of the business.

  • Strengths:
    • Traditional banking model that’s easy to understand.
    • Relatively transparent business model compared to more complex financial companies.
  • Weaknesses:
    • Accounting complexities within the financial statements can be difficult to navigate for lay investors.
    • Difficult to assess impact of interest rate changes on profitability.
    • Unpredictable nature of the banking industry and high dependence on macroeconomic factors, that are harder for a normal investor to understand.

Balance Sheet Health (4 / 5):

Provident has a relatively healthy balance sheet with a rating of 4 out of 5:

  • Strengths:
    • Tier-1 capital ratio is maintained within regulatory limits (8%), providing adequate buffer against losses.
    • Adequate liquidity as indicated by a LCR of 130%, showing the ability to meet short term debt.
    • A strong focus on traditional banking, with a higher proportion of loans relative to other assets, providing a higher return on average assets.
  • Weaknesses: * Recent growth in non-performing loans, and an increase in the provision of loan losses, indicating the possibility of problems in their loan portfolio. * Decrease in Tangible Common Equity Ratio, reflecting higher leverage and reduced cushion for losses.
    • Exposure to real-estate loans, which are sensitive to fluctuations in real-estate markets.

The overall assessment is positive, but there are some risks that make it vulnerable to certain kinds of losses, which is why it received a 4 out of 5 rating. The rising debt and the increasing loan losses should be kept under check for the business to maintain the health of its balance sheet.

Recent Concerns/Problems:

  • The recent Q2 2024 earnings has shown a 41% drop in net profit, primarily because of increased provision for credit losses and lower income from sale of securities. This is an area to keep an eye on to check whether management can rectify this issue.
  • The company’s loan defaults have been increasing steadily over the recent past with non-performing loans to total loans having increased from 0.57% to 2.16% in the past couple of years. This indicates increased risk and management should actively improve their lending practices.
  • The recent debt to equity ratio is quite high at around 9% based on their tangible common equity, which poses concern regarding future capital constraints. Management have said they are actively trying to lower it between 7 to 8%.

In closing, Provident Financial Services is a traditional community bank with some long-term business advantages. However, the presence of a strong competitive environment, some concerns in the financials, and the cyclicality in earnings make it a volatile investment.