In this podcast, Motley Fool contributor Matt Frankel and host Deidre Woollard discuss:
- How new rules could change what you pay in overdraft fees.
- Why banks are socking away money for credit losses.
- The potential advantage for regional banks.
Motley Fool analyst Asit Sharma and host Mary Long take a medium dive into Paycom and discuss a product that could be too good for its own good.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on January 18, 2024.
Deidre Woollard: Paid overdraft fees. Good news ahead. Motley Fool Money starts now. Welcome to Motley Fool Money, I'm Deidre Woollard here with Motley Fool Analyst, Matt Frankel. Matt, how's it going today?
Matt Frankel: Pretty good. It's been a while since I've done one of these with you. I'm happy to be here.
Deidre Woollard: Well, I always like to tap you if we're going to talk about banking and financials because you're one of the people who studies that. You get it in a way that I don't think I quite do. We're going to talk about some regional bank earnings. But before we do, I want to talk about something the Consumer Financial Protection Bureau announced yesterday that I'm trying to make sense of that is around overdraft protection. It sounds like what they're going after is those large overdraft fees that nobody likes. They say they can save people about 3.5 billion. What is this and, how much of an impact is it going to have on banks?
Matt Frankel: First of all, yes, I'm a bank investor, but I'm also a human being first, so I think this is a good thing. Yes, banks make money off fees and this will help people. But you got to realize that the average person who takes an overdraft are like the bank's most vulnerable customers, and the banks are literally taking money from people who don't have any money. It's something that's needed to be fixed for a while now. But just looking through the numbers, this will have an impact on banks for sure, banks make about $9 billion a year on overdraft fees, and of course, the banks are pushing back on this rule. They're a business, at the end of the day, and they're arguing that this is going to make it harder for banks to offer overdraft protection to customers if they're not allowed to charge for it. But on the other hand, the CFPB proposal clearly gives banks permission to recoup their costs, so they're not going to lose money by extending overdraft protection. They can charge a reasonable interest rate if they want to give an overdraft loan, or they can charge a reasonable fee, which is $35, if I overdraft my bank account by $10, is that really a reasonable fee?
Deidre Woollard: No.
Matt Frankel: No, that's 350% interest and most overdrafts are paid back within three days. This is something that needed to be reformed for a while. A lot of banks make a lot of money off these, but it's an income stream that I have to say I'm happy to take the hit on as a bank investor.
Deidre Woollard: Yeah, I would agree with that. It's interesting because you've got the two pathways there where they can either do the loan or they can do that charge. If they do the loan, it sounds like then it sort of functions as any other traditional loan and gets subject to a whole bunch of legislation that way.
Matt Frankel: Yeah. They have to disclose the interest rates and things to that effect. I mentioned that banks make $9 billion on overdraft fees. That's between 175 largest banks. That's not that much. It sounds like a big amount of money and it is, but JPMorgan Chase could afford to absorb that and still be profitable. It's not a giant amount of money in the grand scheme of things, this is not a giant revenue center for the banks. At the end of the day, banks still make the bulk of their money on things like charging interest on loans, investment banking fees, mortgage origination fees. This is not a giant fee income stream for most banks. It will be a hit, but it's not going to decimate their quarterly earnings or anything like that.
Deidre Woollard: Yeah. It's just for the big banks with, I think, it's about over 10 billion, so it's 175 institutions total.
Matt Frankel: Yeah. This is not going to hurt, your local banks can still charge pretty much whatever they want for overdrafts, under this proposal, they're going to have to lower their fees to compete. But yeah, this only affects banks that have over 10 billion in assets and I mean, pretty much every bank that is a household name in America.
Deidre Woollard: Yeah. Well, let's talk a little bit about those regional banks because last week we had the big banks reporting. It seemed to me to be a mixed bag. If the quarter before was a very big quarter for them, this one was a little different, but now we're looking at smaller and regional banks. What questions are you asking yourself as you look at some of these earnings coming in?
Matt Frankel: Like you said, it's a mixed bag so it's kind of definitely on a case-by-case basis what I want to see. Net charge-off rates are a big thing right now. It's looking like we're going to get the so-called soft landing in the economy. A recession would be terrible for banks. Recessions lead to higher defaults, not only that, but much lower loan demand, so they're not originating many new loans, and net charge-off rates at the moment aren't out of control. I'm sure we're going to talk about this a little bit more later, but that's one big thing I'm watching. Deposit bases, a lot of bank customers, myself included, have moved a lot of their balances away from the big banks and even the big regional banks that don't pay very much on checking and savings accounts in favor of higher yield online banks, CDs, and banks are realizing a little too late that they need to raise their deposit yields to compete. Some banks have done a great job of this. Capital One is one example that's been very proactive with competing with the online banks with high-yield CDs and things like that. But banks like Bank of America and Wells Fargo, not so much.
One thing I'm watching is how much of the deposits are still flying out the door, and the answer is quite a bit. Net interest margins are another thing. One thing that people don't realize is, yes, higher interest rates are good for bank loans in the sense that, now, instead of a 5% average rate on auto loans, you're getting about a 10% average rate on new auto loans. But the loans on the bank's balance sheets, for the most part, the majority of them were originated in pre-high interest rate times. Most of their loans are not high-yielding, but 100% of their deposits are becoming higher-yielding. The higher interest rates are actually being more of a negative on the bank in terms of interest margins than a lot of investors would expect. Finally, I'll stop rambling after this. The FDIC's special assessments, speaking of regional banks, are hitting all of the bigger banks, including a lot of the big regional banks, like the ones we're going to talk about, because of those bank failures we had in 2023. Think of this as like if you're HOA, if it has to replace the pool, you might get a special assessment that year that helps them cover the cost of it. The FDIC had to replace a lot of people's money with bank failures, so a lot of the banks are getting hit with special assessments in order to cover it.
Deidre Woollard: Yeah, I've been watching that in the earnings and it's like a shorthand to see how big the bank is depending on how much they had to pay as part of this special assessment.
Matt Frankel: Yeah, and some of them are pretty high. [laughs]
Deidre Woollard: Some of them are very high, especially JPMorgan. You mentioned credit provisions. I want to talk quickly about Discover Financial, which, not a bank but also not a bank, because like AMEX, it takes on the loans itself, and they added a billion to their credit loss provisions. Like you said, the banks are still increasing these provisions and most of the net losses so far, that we've seen, they're below pre-pandemic levels, but they are rising. Should we be worried yet? I'm at the point where I'm like, a year is up. I'm a little worried.
Matt Frankel: Like I said before, it's kind of on a case-by-case basis. Some banks it seems to be progressing better than others, and you're right, the banks are generally increasing their provisions, which means they have enough in reserves to cover what they expect to lose and then a little bit more. Wells Fargo, for example, raised their provision by 34% year over year in the fourth quarter, fueled by credit cards and commercial real estate loans, surprise. I know we'll talk about commercial real estate a little bit later. But if you look at the two big regional banks that reported this week, US Bancorp and Truist Financial, one is significantly lower than pre-pandemic rates. That would be US Bancorp, and their charge-off rate is three basis points lower than in comparable 2019. Remember, in 2019 the economy was doing very well, so that's a strong pre-pandemic time. But on the other hand, Truist is about 10 basis points higher than it was in comparable 2019 times, and not only that, right now their net charge-off rate is 0.5%. They're expecting that to rise to 0.65% in 2024. That would be significantly higher than pre-pandemic levels. Like I said, it's kind of a mixed bag. Truist is one of the few banks that actually gives forward guidance on that, so it's really tough to, know what management's thinking when it comes to net charge-offs in a lot of cases. But yeah, it's making me take notice, and it's making me a little bit cautious and a lot of banks are projecting revenue to decline a little bit year over year in 2024, and that's a big reason earnings to decline.
Deidre Woollard: Well, you just mentioned US Bancorp. I was listening to their earnings call. One of the things they talked about was the cost of retaining customer deposits, and that they're really having to to go out there and spend more money than they used to. Is this something that's impacting a lot of the regional banks?
Matt Frankel: Absolutely. US Bank Corp mentioned it. Truist actually gave some really great figures on that. That interest margin fell by 27 basis points here every year. Here are the stats. This is what I was talking about with, a lot of the loans on their balance sheet are still paying low yields from years ago while all of their deposits are now higher yielding. The yields on Truist earning portfolio are up by 95 basis points here every year. Meaning that their average loan is paying 0.95% higher of an interest rate than it was a year ago. The average cost of its interest-bearing liabilities, which primarily means its deposit base, is up by 164 basis points here every year, so 1.64%. It's not only the deposits are at higher yields, the cost of banks to, say issue long-term debt, is a lot higher than it was. The cost to borrow, this is what the federal funds rate is all about. The Feds benchmark interest rates are, the inter-bank lending rates, those are a lot more. Banks are paying a lot more on capital than they're making on loans, but they're still not paying as much as a lot of the higher-yielding options like online CDs and things like that. The cost of retaining customer deposits is a concern, and not only is it a concern, yes, it's costing more, but it's not terribly effective. If I'm looking at their deposit basis, yes, banks are retaining their deposits, but Truist lost a total of $23 billion of deposits over the past year, 23 billion, and this is a regional bank, this isn't one of the giant ones, and they're a regional bank that operates in pretty attractive market environments in the Sun Belt region. Yes, they need to pay more to retain their deposits, but customers are still looking to maximize yield and you're not going to do that with branch-based banks for the most part.
Deidre Woollard: Truist is interesting because they reported their earnings, they had a loss, and they're forecasting a revenue drop of about 1-3% for the fiscal 2024.
Deidre Woollard: But they also talked about that regional advantage that you just talked about. They're in the Sun Belt area. I was thinking about this as an overall look. Last year we had after the banking crisis, we had that flight to safety to the big banks. Then we had what you talked about right now, the rate chasing. All of a sudden everybody realized, if I put my money over in a CD or in one of the online banks, maybe I can get a better rate. Now I'm not sure what the financial story is, and looking at Truist is that regional advantage, they see it as a huge thing. I don't know. What do you think?
Matt Frankel: I would say yes, I'm in Truist country. I don't know if there are Truist branches up where you are.
Deidre Woollard: Yeah.
Matt Frankel: I'm definitely in Truist country. If everyone knows they came from BB and T and SunTrust, and if he didn't know that, you know that now. SunTrust was a big bank in Florida. That's where I had my bank account when I lived down in Florida. It's generally market environments, not all of their markets, but most of their markets have above average wage growth, above average job growth, positive net migration, which has been a big trend since the pandemic started into the Sun Belt region. Relatively affordable housing costs, which is very attractive. People could still afford a mortgage there. I think it is an advantage, it's going to be more of a long tailed advantage, however. I think I could see it fueling growth better than, as opposed to a bank that's based primarily in New York and New Jersey, where you're seeing population outflows over time or at least slower net migration. I'm from New Jersey and most of my friends have gotten out of there. No offense to New Jersey. But I do see it as an advantage, but not a big enough differentiator that that is the investment thesis all by itself.
Deidre Woollard: Well, with regional banks, we've also got commercial real estate as a bigger portion of things, you and I can't get together without talking about real estate. I'm pretty sure that's in our contract. Let's do that. With Truist, you've got a fair amount of commercial real estate loans. We both keep an eye on this. Last year the big concern was office. But I'm also starting to look at multifamily for signs of weakness. This is traditionally a really safe area. It's around 33% of Truist loans. There's not a vacancy problem with multifamily the way there is with office, but there is a rent growth slowing problem. What are you thinking about commercial loan liability for regionals right now?
Matt Frankel: It's really interesting you mentioned multifamily. Like you said, everyone always talks about other property types, specifically office. When you hear about the commercial real estate crisis, it's usually referring to office. There's a lot of empty office buildings in my town, I'm sure there's a bunch near you. But multifamily, it's a really interesting thing in that there's a lot of refinancing risk that's going to happen in the next few years. I recently interviewed Willy Walker, the CEO of Walker and Dunlop. They're the biggest multifamily focused commercial real estate finance company in the US. He pointed out that over the next three years, 2024 through 2026, there are over three times as much multifamily loan volume that will need to be refinanced as in the last three years. A lot of these loans, multifamily loans are not the mortgages that you and I would get to buy a house in that you just pay your mortgage, the balance goes down over time. They're generally interest only loans that need to be refinanced every so often, and a lot of them are coming due within the next few years. I'd be curious to see how many of those are Truist loans. I only know the data for Walker and Dunlop's loans because banks don't break out individual loan data usually. But I would have to say that that refinancing proportion is probably consistent with what you're going to find in Truist's portfolio. That's a big risk, especially if interest rates stay elevated.
That's a big if right now most experts expect interest rates to fall over the next year or two. The question, it's going to be a real balancing act between how much refinancing volume is coming due and the interest rates you can get because you know as well as I do, commercial real estate assets derive most of their value from how much they earn their owners over and above the cost of ownership. There's not a vacancy problem in multifamily, there is still a housing crisis in the United States. So there's a lot of demand. The US economy has the ability to absorb, depending on who you ask, about three million new housing units. Most of that would be multifamily housing, not single family. There is a lot of demand, that's the good thing that there is that refinancing risk and that's what I would be keeping an eye on.
Deidre Woollard: Me too, especially. The interest rates remain this unknowable question for the future. Well, thanks for breaking it down with me today, Matt.
Matt Frankel: Of course, glad to be here.
Deidre Woollard: We talk about a lot of stocks on the show, but it's just a peek at the Motley Fool's investing universe. This year we're rolling out a new offering, it's called Epic Bundle. The service includes seven stock recommendations every month, model portfolios and stock rankings, all based on your investor type. We are offering Epic Bundle to Motley Fool Money listeners at a reduced rate, as a thanks for listening to the share. For more information, head to www.fool.com/epic198. We'll also include a link in the show notes for you. Up next. Asit Sharma joins Mary Long for a closer look at a company that might just help you get paid.
Mary Long: So Paycom is a software as a service, a SAAS company that provides human capital management solutions. Basically what that means is it's a company that helps other companies keep track of their employees, they use this phrase, from recruitment through retirement. There are a handful of other companies that offer similar services, many also happen to start with pay. But from the user, the employer perspective, what differentiates Paycom from its competitors?
Asit Sharma: Mary, if you are a user of Paycom, let's say that you administer human capital management solutions in your company, it's got a bit of a nifty edge over some other software services you can look at. For example, this company takes information from the background check of a potential employee all the way through employment. They happen to be one of the biggest background check companies in the US, it's part of their revenue stream. But from the beginning, Paycom decided that it wanted to pull information forward so that businesses didn't have to keep reentering bits of information, and another interesting thing that they do is they develop most all of their services in house, they love to develop software internally. If you're using their system, you get a nice dashboard, you can move around quite easily from one part of the service to another, from the payroll administration, to looking at benefits for your employees, to tax filings, which happen to be automated, it is one of the great services they offer, they can automate that whole worrisome process of filing quarterly returns for your company through the software. I think that it attracts on the basis of usability for businesses that are looking at it and functionality. We'll get a little bit into its automation creds in just a bit, but those are the major reasons that attract users to the platform.
Mary Long: From an investor perspective, one of the things that sticks out when I look at Paycom are its gross margins. They've been hovering at about 84% since 2016. That's higher than a lot of its competitors like ADP, Oracle paychecks, Paylocity. What's the story there?
Asit Sharma: One of the things that you must do if you are in this business is to strike a balance between payroll administration and then offering all these other services that line up under that human capital management banner that you and I were both mentioning. How employees can save for retirement, what types of benefits they're eligible for, working with wage garnishments, there's an innumerable amount of services that you have to offer. The approach of big payroll providers like the ADPs and paychecks and the oracles of the world has been to acquire smaller companies parts and pieces to be able to offer everything to the businesses that they deal with. But this becomes a little bit of a clunky exercise from a user interface experience, and it also leads to, I think, a bit of a higher gross margin for Paycom since they develop everything, as I said before, internally. If you're not trying to buy smaller companies and then spend money to integrate the services and then spend money on the support when things don't work out, you actually have a smoother sales to cost of revenue relationship. I think that leaves you more or a bigger chunk, I should say, to then have your fixed cost run against, which leads to hopefully, a better operating margin as well.
Mary Long: There are all these different elements and segments of the solutions that Paycom offers. Are they all or nothing? Do companies have to buy into everything or are there certain segments that garner a lot of attention and traction and others that not so much?
Asit Sharma: This is a great question. Paycom is a little different than most of the companies you'll look at, be they really big or just small entrants into the space, and that their pricing is opaque. You can't go online and try to Google up a chart of Paycom services versus ADP's. We don't have a very clear picture on exactly how the services are offered up, but what we do know is that Paycom wants to sell its customers everything in one place solution, that's the default, but they will offer businesses the ability to choose a la carte bits from their menu. You can go either route, but what they're going to try to do upfront is to say, look in the single pane of glass, a single dashboard, you get all our features for X Price.
Mary Long: You teased out that automation piece. I feel like today you can't look at Paycom without catching wind of this thing called Betty. It's not a person, it's a service. Maybe let's start with what is Betty.
Asit Sharma: Betty is basically an app that allows an employee to enter his or her own information on benefits and also time during a payroll period. This cuts down errors for the company that's running the payroll. This is a really great thing for companies because it's notoriously difficult to get a payroll right especially when you have, let's say, a flux of employees coming and going. For businesses that experience that payroll is really difficult. It's a cost center. What Betty does is allows the data source, that's the employee, to input the information. When you cut down those errors, you cut down the reruns of payroll. What we heard from Paycom last quarter is yes, Betty is getting a little bit too good for its own good because with this reduction in error, those are fewer extra payrolls run. That actually cannibalizes a bit of revenue. Now, Chad Richison, the CEO, has been pretty adamant his whole career that he wants the best outcomes for customers. He is willing to take a little bit less revenue. If the user experience is better for the customer, he will sell them more value-added products down the line. I think we've got a really temporary blip here with the company. There's one other part of that puzzle that investors should pay attention to. There is a group that upsells services within this company. They have been growing year after year. Last year was the first here that they pulled back a little bit and said, instead of trying to upsell, we're going to spend more time on client premises with customers helping them get value for the products that they have. Richison was a little concerned that they were doing too much upselling, so that also hit the top line and the projections for this year. A little kink there, but I believe it's a blip in a longer-term story that looks pretty bright.
Mary Long: Paycom is a software company; it's also profitable, it's also quickly growing. It also pays a dividend. All of this feels rare for a software company, and yet in large part because of these cannibalization and worries connected to Betty that we talked about, the stock has slumped a lot after its latest earnings call, which happened in November of last year. The stock is now trading at under 35 times earnings. That's basically half of what it was in 2022, and it's down from over 180 in 2020. How are you thinking about valuation right now? Do you feel that this is just a massive buying opportunity that others are missing?
Asit Sharma: I don't think it's massive. I think it is a buying opportunity. But investors who invest in the payroll industry, I think are looking for a few more things out of this company. Number one, their customer service really isn't up to par. They spent so much time investing in really a seamless experience without integrating a bunch of third-party tools that they have under-invested in areas where their bigger competitors have been really on the ball. One quick example, paychecks since like 2018 has been using AI to invest in customer-facing bots, so people can get quick answers when they have issues with their payrolls, and to date we don't see that out of this company. I think also there are a few other friction points because they are, so let's do everything in-house. They don't have a great API or an API that I've seen that easily connects to benefit providers. There's this whole interchange between benefit providers that is a little easier with the bigger platforms that this company doesn't have. They need to work on that as well. Thirdly, I think people are wondering if there's another company which builds something from the ground up as well. Is this more of an idea or a competitive mode? Mary, maybe you and I, if we were really technically skilled, could try to build something similar with the idea that let's get the data first off when someone comes through the door and let that follow them through the organization and also offer an app where they can put this information in and have these seamless perils. That itself isn't something that's unassailable, but for their bigger competitors, they really don't want to pull their customers out of their models that currently exist. It's really, really hard to tell a company, we're going to do something similar to this process you've heard about. But it'll take four weeks of implementation and the perils will be manual during that time. This is one edge that Paycom has. It's really difficult to recreate it on an enterprise level, but I think investors are just weighing the puts and takes of this and saying, yeah, it's probably a buying opportunity, but it's not that the whole market has missed this story here, they see it realistically.
Mary Long: Chad Richison is the CEO of Paycom. He founded the company in 1998 and again remains at the helm to this day. We love a founder-led company here. Do you have any particularly strong takes on Richison, his vision, his leadership, or how he's executed that vision?
Asit Sharma: Sure, let's get the elephant out of the room first. I mean, Richison has one of the most lucrative pay packages in all of Wall Street. He got, I think, $200 million worth of stock incentives a few years ago that if Paycom stock performs could be worth into the billions in a few years. He's gotten a lot of push back from that. Now on the other hand, what I like about him is he's performed, this is a company that's really outperformed since they've been public. As you point out, very cash flow positive. They are contemplating more share buybacks. They have initiated a dividend, and I like Richison's lean attitude toward running his business. He doesn't like debt, so they've paid down all their debt. I think except for maybe $29 million. They like to generate the cash and then invest it. There's not a lot of waste in the organization and he's been pretty good at inspiring his employees to go and fight against the bigger players by developing their own stuff. I think he's kept the R&D engineers very happy at Paycom. They like to innovate and I think they will continue to. I think in terms of vision leadership execution, he's got all that. The company has historically deserved the multiples, the rich multiples the market has given it. It's just with this bump, with Betty starting to look like it may be too good for its own stuff. You do have this crossroads for the business and the stock. But we'll see, we'll monitor it this year, quarter by quarter, maybe you and I can chat again later this year and see how they're doing.
Mary Long: Yeah, we can do a check-in. If things don't go according to plan, then that side hustle that you mentioned of us starting our own version of Paycom sounds like a promising opportunity.
Deidre Woollard: As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Deidre Woollard. Thanks for listening. We'll see you tomorrow.
