Coastal Financial Corporation (NASDAQ: CCB)

May 07, 2024

Coastal Financial Corporation (NASDAQ: CCB), referred to as “Coastal” or “the bank” for the remainder of this writeup, is a bank holding company with high returns on equity located in the Puget Sound region of Washington state. Its primary activities include two segments: Community banking in Snohomish County and Banking as a Service (“BaaS”) products offered through its CCBX division. The bank is headquartered in the mean streets of Everett, Washington. Per its 2023 10-K, “As of December 31, 2023, we had total assets of $3.75 billion, total loans receivable of $3.03 billion, total deposits of $3.36 billion and total shareholders’ equity of $295.0 million.”

History

Per Coastal’s prospectus, “We are a Washington corporation that was formed on July 9, 2003, to become the holding company for Coastal Community Bank, which commenced operations in 1997 and to which we refer in this prospectus as the Bank. The Bank was formed by local business leaders who recognized the opportunity to create a bank that could meet the financial needs of the community locally and support the communities it serves.” The bank boasts 14 full-service branches, with 12 being located in Snohomish County, one in Island County, and one in King County. The CCBX segment was created in 2018 to provide banking services to Fin-Tech businesses and broker-dealers. The business went public in October of 2018.

CEO

Erik Sprink has been the CEO of Coastal since 2010. He joined the bank in 2006 as President and Chief Operating Officer. Per the 2023 10-K, “Mr. Sprink began his banking career working for Security Pacific Bank while enrolled at Arizona State University. He assumed increasing levels of responsibility in the areas of retail operations, consumer and commercial lending and wealth management with Security Pacific Bank and its successor, Bank of America. He then moved to Centura Bank, where he held management positions in retail operations and corporate finance. After Centura Bank was acquired, he held senior management positions at Washington Trust Bank and Global Credit Union. Mr. Sprink received a bachelor’s degree from Arizona State University and an M.B.A. from the University of North Carolina.”

CEO Compensation

Mr. Sprink’s compensation is comprised of a base salary, a discretionary cash bonus, stock awards, a non-equity incentive plan, and other compensation. I will only discuss the first four elements as they make up more than 96% of his total compensation.

Mr. Sprink’s base salary in 2021 and 2022 was $700,000. His salary for 2024 bumped up to $810,000.

Mr. Sprink did not receive a discretionary cash bonus in 2021 or 2023 but did receive one for ~$83,000 in 2022. There was no additional information provided about what the cash bonus currently is or has been based on.

From what I could gather, the stock awards and non-equity incentive compensation both fall under Coastal’s “Executive Incentive Plan” which is described in detail on pp. 31-33 of the 2024 Proxy Statement.

The stock awards are comprised of varying amounts of time-based and performance-based Restricted Stock Units (RSUs). However, in 2023, only time-based RSUs were issued to Mr. Sprink. The non-equity incentives appear to be paid out in cash. Both elements of the “Executive Incentive Plan” are linked to several performance metrics and corresponding thresholds. If you’d like to read more about the “Executive Incentive Plan”, then you can read the next two paragraphs, the corresponding screencap which lists the performance metrics, their hurdle rates, their overall weighting as part of the “Executive Incentive Plan”, and my comments on the performance metrics. If you don’t want to read more about it, then you can skip to the table that shows Coastal’s performance versus its stated benchmarks and continue reading from there.

Per p. 31 of the same Proxy Statement, “The Company maintains an Executive Management Incentive Plan (the “Plan”) for certain key officers, including the NEOs, to align executive compensation practices with the Company’s performance, strategic plan and long-term goals. Under the Plan, the Company provides for incentive compensation to NEOs in the form of cash and equity that are contingent upon the achievement of certain performance objectives. The long-term equity incentives paid in 2023 consisted only of time-based restricted stock units (“RSUs”). Time-based RSUs are critical to our compensation program. Time-based RSUs tie our NEOs to future Company performance through the stock value and reinforce actions that build long-term shareholder value. Performance-based RSUs were awarded to the CEO and President in 2021 and 2022, respectively. These performance-based awards cliff vest based on stock price and performing in the top 10% of a comparator group comprised of a subset of publicly-traded commercial banks and are designed to reward the executive for creating shareholder value.”

Per p. 32 of the 2024 Proxy Statement, “The compensation paid out as a result of achieving these goals is paid out 50% in cash and 50% in RSUs that vest over a four-year period. The CEO has the option to recommend an adjustment to the payout for all NEOs other than himself. In 2023, the Compensation Committee selected goals were (i) Return on Average Assets, (ii) Return on Average Equity, (iii) Core Deposit Growth, (iv) Gross Loan Growth, (v) Net Charge Offs and (vi) Strategic Objectives. Each of these goals were selected to support the strategic goals on the Company in its effort to increase shareholder value. The weighting of the goals was set by the Compensation Committee to maintain a balance of the different objectives. Strategic objectives include a variety of Company-specific goals related to Leadership, Team Development, Compensation Strategy and Framework, and Long-Term Capital Framework.” Shown below are the performance objectives, their benchmarks, and their overall weighting towards Mr. Sprink’s portion of the “Executive Incentive Plan”. The image was taken from p. 32 of the 2024 Proxy Statement.

I do like the hurdle rates for the return on average assets and return on average equity. Gross loan growth of 10% could be a little higher at 12% - 15%, but it’s not terrible. The core deposit growth, net charge-offs, and the company strategic objectives were concerns. Core deposit growth of 5% isn’t a very demanding hurdle rate. The charge-offs percentage looks good, but there is a major exception to it which is that only the community bank segment charge-offs were considered. The CCBX segment, which has recorded sizeable amounts of charge-offs over the last couple of years, was not included in the net charge-off calculation. I will discuss charge-offs in greater detail later in the writeup. My concerns with the “Company Strategic Initiatives” listed above were that all the factors listed were qualitative so I wondered how the Compensation Committee measured them.

The screencap below, taken from p. 33 of the 2024 Proxy Statement, shows Coastal’s results versus its benchmarks.

A quick look at the table would make you think that Coastal is knocking the cover off the ball. However, the core deposit growth was almost 5x its target making me question how difficult it was to achieve. Net charge-offs were low, but pay attention to Note 1 that is highlighted regarding the charge-offs in the CCBX segment. The “strategic objectives” are purely qualitative, yet somehow the business achieved 100% of them.

The summary compensation table, taken from p. 36 of the 2024 Proxy Statement, is shown below.

There was still a bit of confusion on my end regarding Mr. Sprink’s Bonus compensation and his Non-Equity Incentive Plan compensation which I have mostly figured out. The “Bonus” column is a discretionary amount of money paid to the NEOs by the company every year. As I stated above, I was unable to find what the metrics were to qualify for this bonus. Given that they’re discretionary, my guess is that the metrics can be whatever the company wants. The stock awards are the value of the vested RSUs awarded to Mr. Sprink. The non-equity incentive plan compensation is the other 50% of the value of his total “Executive Incentive Plan” compensation for the year paid out in as a cash award based on the metrics/hurdle rates above.

The last point I’ll mention regarding Mr. Sprink is that he does have some skin in the game. He beneficially owns 248,892 shares of the business through common stock holdings and exercisable stock options which puts his ownership at 1.85% of the business. I’d like to see more in terms of percentages, but the dollar amount is conservatively in the high single digit millions when accounting for the current value of common shares at ~$40/share and the spread between the value of 84,256 option shares at an exercise price of ~$10.

What Does Coastal Financial Corp Do?

Coastal, like all banks, offers deposits and loans to its customers. It operates through its Community Bank, CCBX, and Treasury and Administration segments. Per the 2023 10-K, “The treasury & administration segment includes investments, debt and other reporting items that are not specific to the community bank or CCBX segments.” While this segment does generate interest income, it is mostly due to investments in US government bonds and mortgages. Per p. 9 of the 2023 10-K, “At December 31, 2023, 66.1% of our investment portfolio consisted of U.S. Treasury securities. The remainder of our securities portfolio is invested in U.S. Agency collateralized mortgage and U.S. Agency residential mortgage-backed securities obligations.” The bank also has a $2.6 million in equity investments in both bank technology companies and bank technology funds. Its total investment portfolio totaled $150.5 million as of 12/31/23. The rest of this section and the writeup will focus on the Community Bank and CCBX segments as those are the core operations of the business.

The Community Bank segment serves the Puget Sound region of Washington State. Per p.3 the 2023 10-K, the bank is … “the largest locally headquartered bank by deposit market share in Snohomish County, according to data from the FDIC as of June 30, 2023, at which date we had a 15.8% deposit market share in Snohomish County…” This figure is up from its 5% deposit share as of the publishing date of its prospectus.

Per p. 3 of the 2023 10-K again, “Our CCBX market extends throughout the United States through our broker dealers and digital financial services partners. Our CCBX partners make our banking products and services available to their consumers, partners and workforce through integration with our banking platform. In doing so, our addressable market expands to a broader spectrum of consumers as well as small businesses. Working with our CCBX partners allows us to provide a broader range of services for different demographics through their offerings. Developing the kind of unique offerings to specific under-served or under-banked populations would be difficult for a bank our size, but through our CCBX partnerships we are able to use our banking charter to support this effort in a much broader scope.”

Regarding its deposit products on p. 8 of the 2023 10-K, “We provide a full range of deposit products in the community bank and through our CCBX partners that have a wide range of interest rates and terms, including a variety of demand and savings accounts, time deposits, and money market accounts. We also provide a wide range of deposit services, including debit cards, remote deposit capture, online banking, mobile banking, and direct deposit services. We also offer business accounts and cash management services, including business checking and savings accounts, and treasury services. We also offer reciprocal deposits which enables us to extend FDIC insurance to customers that have balances in excess of the FDIC insurance limit. This reciprocal deposit service trades our customer’s funds in increments under the FDIC insured amount to other participating financial institutions and in exchange we receive customer deposits from participating financial institutions in a reciprocal agreement.”

The bank offers several kinds of loans to its customers. They are commercial and industrial loans, commercial real estate loans, construction, land and land developments loans, residential real estate loans, and consumer and other loans. I have described them in detail below, if you’d like to learn more about them. If not, you may jump down to the Deposit and Loan Analysis section.

Commercial and industrial loans are offered through the community bank and CCBX segments. Per p. 4 of the 2023 10-K, “We make commercial and industrial loans, including term loans, commercial lines of credit, capital call lines working capital loans, equipment financing, borrowing base loans, Small Business Administration (“SBA”) loans, and other loan products, that are underwritten on the basis of the borrower’s ability to service the debt from income. We take as collateral a lien on general business assets including, among other things, available real estate, accounts receivable, inventory and equipment and generally obtain a personal guaranty from the borrower or principal. Our commercial lines of credit typically have a term of one year and have variable interest rates that adjust monthly based on the prime rate.”

Included in commercial and industrial loans are capital call lines to venture capital firms. The best definition of a capital call line came from Silicon Valley Bank which describes them as “… a facility provided by a financial institution (i.e., Silicon Valley Bank) in exchange for interest. General partners (GPs) draw funds from these facilities on a regular (often quarterly) cadence instead of calling capital directly from limited partners (LPs).” If you’re wondering why a community bank in Washington state is providing capital call lines to VC firms, then we’re in the same boat.

Commercial real estate loans are only offered through the community bank segment. Per p. 5 of the 2023 10-K, “We make commercial mortgage loans collateralized by owner- and non-owner-occupied real estate, as well as multi-family residential loans… The real estate securing our existing commercial real estate loans includes a wide variety of property types, such as manufacturing and processing facilities, business parks, warehouses, retail centers, convenience stores, hotels and motels, office buildings, mixed-use residential and commercial, and other properties.”

Construction, land, and land development loans are only offered through the community bank segment. Per p. 5 of the 2023 10-K, “We make loans to established builders to construct residential properties, to developers of commercial real estate investment properties and residential developments and, to a lesser extent, loans to individual clients for construction of single family homes in our market areas. We also make loans for the acquisition of undeveloped land. Construction loans are typically disbursed as construction progresses and carry either fixed or variable interest rates. Our construction and development loans typically have terms that range from six months to two years depending on factors such as the type and size of the development and the financial strength of the borrower/guarantor. Loans are typically structured with an interest only construction period and mature at the completion of construction.”

Residential real estate loans are offered through the community bank and CCBX segments. Per p. 6 of the 2023 10-K, “We make one-to-four family loans to investors to finance their rental properties and to business owners to secure their business loans.”

Consumer and other loans are offered through the community bank and CCBX segments. However, almost all of these loans are originated through the CCBX segment as described below in the Deposit and Loan Analysis section. Regarding the CCBX consumer and other loans on p. 6 of the 2023 10-K, “Consumer loans typically have shorter terms, lower balances, higher yields and higher risks of default than residential real estate mortgage loans. Consumer loan collections are dependent on the borrower’s continuing financial stability and are therefore more likely to be affected by adverse personal circumstances, such as a loss of employment, divorce, or unexpected medical costs.” Per the same page, consumer and other loans originated through the Community Bank segment offer a “…variety of consumer loans to individuals, mainly business owners and family of business owners, for personal and household purposes, including automobile, boat and recreational vehicle loans and secured term loans. We also offer personal lines of credit including overdraft protection. Consumer loans are underwritten based on the individual borrower’s income, current debt level, past credit history and the value of any available collateral.”

Deposit and Loan Analysis

The next section of this writeup will be an analysis of Coastal’s deposits and loans.

Deposits

Shown below is Coastal’s deposit portfolio since 2014.

Total deposits have CAGR’d at a 21.68% clip since 2014 and at 26.93% since the business IPOd in 2018. While the growth is impressive, I do have concerns about its deposit profile, especially noninterest bearing deposits.

Noninterest bearing deposits routinely made up 30-40% of total deposits at the bank before the creation of the CCBX segment and peaked in 2021 at 57% of total deposits. Since then, the number has dropped precipitously to 19%. That is obviously not want you want to see at a community bank. Ideally, noninterest bearing deposits would be at or above 40%. CCBX’s portion of noninterest bearing deposits peaked in 2021 as well at $636.6 million and subsequently plummeted to $80.8 million in 2022. The screencap below from p. 128 of the 2022 10-K explains why noninterest bearing deposits dropped so significantly between 2021 and 2022.

I questioned whether these deposits should’ve been able to be labeled as “non-interest bearing” in the first place, but I decided to let it slide.

A smaller, minor concern is that the Community Bank segment saw its noninterest-bearing deposits drop $132 million to $561.6 million 2023.

On the interest-bearing side, the CCBX segment has taken off like a rocket ship since 2021. This segment’s portion of interest-bearing deposits now makes up a majority of all interest-bearing deposits and total deposits. The CAGR from its $38.5 million in interest-bearing deposits in 2020 to its $1.8 billion in interest-bearing deposits as of year-end 2023 is 161.38%. Describing that as “hockey stick” growth is underselling it. This massive growth was also a cause for concern because I wasn’t sure how a community bank would handle such an increase in loan volume in such a short amount of time.

To reinforce what I stated earlier, I’m not thrilled with Coastal’ deposit base. It boils down to its low percentage of noninterest-bearing deposits to total deposits. Having more than 80% of your deposits bearing interest doesn’t give management a lot of room for mistakes or problems with its loans.

Loans

Shown below is Coastal’s loan portfolio.

The first thing I’d like to mention regarding Coastal’s loan portfolio is that PPP loans had a significant impact in 2020 and 2021. PPP loan balances at 12/31/2020 were $365.8 million and at 12/31/2021 were $111.8 million. Backing these out would’ve brought the Community Bank segment’s Commercial and Industrial portfolio down to ~$106 million and $104.4 million respectively. PPP loan amounts in 2022 and 2023 were <$5 million for each year.

The biggest exposure for the Community Bank segment by far is its commercial real estate portfolio with $1.3 billion in loans. The screencap below shows Coastal’s commercial real estate exposure by industry and was taken from p. 83 of the 2023 10-K.

More than a quarter of its commercial real estate loans are for apartments in the Puget Sound region. It has relatively low exposure to office space at $89 million. Per its most recent investor presentation, linked here, the office loans are suburban properties with $67.9 million of these loans having loan-to-value of 70% or less and no delinquencies as of 12/31/2023.

CCBX’s loans, like its deposits, have taken off like a rocket ship since 2020, but slowed considerably from 2022 to 2023. I don’t like saying this but, I had questions or concerns with all of its lending categories.

First up were its Commercial and Industrial loans. CCBX’s 2020 and 2021 Commercial and Industrial loans were all Capital Call Lines to venture capital firms. If you recall from earlier, I have no idea why Coastal offers these. Given the hit rate of VC firms, these seem risky in the best-case scenario. The exposure to Capital Call Lines decreased in 2022 and 2023 to $146 million and $87.5 million with the rest of the Commercial and Industrial loans being labeled as “other Commercial and Industrial loans”. The final concern I had with this segment was a note from p. 81 of the 2023 10-K that states, “Commercial and industrial loans includes $48.6 million and $45.1 million in loans to financial institutions as of December 31, 2023, and December 31, 2022, respectively.” Again, I have no idea who these financial institutions are or why Coastal is lending to them.

Next up was CCBX’s residential real estate portfolio which was comprised solely of home equity lines of credit. This is a preference thing, but I just don’t like seeing a bank that has a material amount of these kinds of loans in its portfolio. There was no additional information provided in the filings I read through about who these loans are going to or what purpose they’re using them for. The table below, taken from p. 84 of the 2023 10-K, reinforces my concerns about the home equity lines of credit. Why does the CCBX segment have such a large exposure to home equity lines of credit while the Community Bank segment doesn’t and hasn’t traditionally? What is so much better about lending through CCBX?

Last up were CCBX’s Consumer and Other loans. The screencaps below give a description of these loans and their totals for 2022 and 2023 and were taken from pp. 82 and 84 of the 2023 10-K.

I’m beating a dead horse here, but I just don’t want to see a community bank with this much exposure to credit card and installment loans. If these loans were so great, then why didn’t the Community Bank segment increase its exposure to them historically?

Ratio Analysis

In my two previous writeups on banks I referenced ratios from Analyzing and Investing in Community Banks (referred to as “the book” going forward) which I read a few years ago. I applied the same balance sheet, income statement, and asset quality and coverage ratios to Coastal along with additional calculations on its allowance for loan losses, provision for credit losses, and net-charge offs.

Note: I started my analysis from 2016 because that was the first year I could get near complete information for each ratio.

Balance Sheet Ratios

Coastal didn’t really knock it out of the park with its Balance Sheet Ratios. Tangible equity and its liquidity ratio were fine, but backing out its interest bearing deposits at other banks would ruin its liquidity position. I wasn’t sure how to judge this because there wasn’t a description about these kinds of deposits in the filings I read, but I gave Coastal the benefit of the doubt to be generous.

Its loan to deposit ratio is high and has exceeded 85% since 2016. Besides having a high loan to deposit ratio, the types of loans provided through its CCBX segment are a major cause for concern as mentioned above.

Borrowings to deposits is solid and doesn’t seem to be a concern.

DDA/Total deposits were fantastic up until 2021, but have plummeted ever since. As I stated earlier, the ideal amount of DDAs (noninterest bearing deposits) would be around 40% and Coastal isn’t anywhere near that currently.

Income Statement Ratios

*** For some reason, its public filings didn’t show or mention any of Coastal’s income state ratios for 2021. I’m guessing this was due to COVID, but I don’t know for sure. ***

Coastal does a pretty good job with its return on average assets. Anything north of 1% is solid and it has been able to meet or exceed that target since it went public.

Return on average equity looks good. North of 10% is ideal and Coastal has managed to exceed that hurdle every year since it went public with a noticeable uptick in performance over the last two years.

Net interest margin, like its return on average equity, has ticked up considerably over the last two years. However, this is due to Coastal’s exposure to higher interest loans rather than a cheap deposit base.

Loan loss ratio looked good until 2022 when it popped significantly. Again, this is another concern I have with the bank. A loan loss ratio of a few percent or approaching 5% for more than a year or two can ruin a bank’s earnings. Per the book, a loan loss ratio that increases sharply indicates that management may not have been paying attention to the deterioration taking place within its loan portfolio.

Its efficiency ratio is great. The bank’s operating costs relative to its income are low, which is exactly what you want to see.

Analyzing and Investing in Community Banks doesn’t give a target of what non-interest expense or non-interest income to average assets should be. In a perfect world you’d want non-interest expense to average assets to be low and non-interest income to average assets to be high as long as the income is sustainable and high quality. I have a series of questions about Coastal’s non-interest income and overall business at the end of the “Segmented financial information” section of this writeup.

Asset quality and reserve coverage ratios

Coastal scores well with its NPA ratio. The book states that an NPA at or below 1.25% is what you want to see in “good times”. Not really sure what “good times” means, but Coastal only exceeded that amount in 2023.

Loan loss reserves to gross loans increased substantially in 2021 due mostly to COVID and the economic environment at the time, and has decreased considerably since, although it remains materially higher than 2019 and before.

Coastal scores well on its ratio of loan loss reserves to NPAs (non-performing assets). A ratio of at least 200% is what you want to see, and the bank has managed to exceed that every year since 2016, although the ratio has fallen considerably since 2021 where it is now just above that 200% threshold.

Allowance for loan losses, provision for credit losses, and net charge-offs

I calculated these amounts and broke them out by segment to highlight further concerns with Coastal’s CCBX segment. All three of the calculations are shown in the screencap below.

What the calculations show is that CCBX, while experiencing rapid growth in its loan portfolio, seems to be taking on a lot of risky and undesirable loans as evidenced by the eyewatering increases in its allowance for loan losses, provision for credit losses and net charge-offs. This seems to partly answer my questions earlier about the quality of its loans.

A second key takeaway here is that the Community Bank segment seems to have a much more conservative underwriting culture than that of CCBX. Its allowance for loan losses, provision for credit losses and net charge-offs over the last three years are dwarfed by those of the CCBX segment.

Segmented financial information

Perhaps nothing showcases the issues at Coastal better than the summary financial information tables on pp. 76 – 77 of the 2023 10-K. The financial figures given are for 2021, 2022, and 2023, and they do a great job of highlighting the issues with the CCBX segment. The screencaps are shown below.

You can again see the explosive growth in the CCBX’s net interest income from 2021 – 2023. The problems start right after though. The provision for loan losses wiped CCBX’s interest income in both 2021 and 2023, and reduced it by 86% in 2022.

It’s CCBX’s non-interest income that is both its saving grace and deserving of further scrutiny. This line item increased more than 11.5x in two years due mainly to “BaaS indemnification income”. I read about this in their public filings and was immediately suspicious of it. The text in the screencap below, which describes its “BaaS credit enhancements” and “BaaS fraud enhancements” which together equal Coastal’s total “BaaS indemnification income”, was taken from pp. 106 – 107 of the 2023 10-K. I copied and pasted it into a Word document so it would all fit on to one page.

First off, there was $177.8 million was recognized as “BaaS credit enhancements”, but on the summary financial table above the total indemnification income is $184.9 million. The $7.1 million spread between the two were due to “BaaS fraud enhancements” which work in the same manner as the “credit enhancements”.

An immediate eye raiser is the wall of text. Its 516 words and not an easy structure to understand. The TL;DR version I can give you is that Coastal has an agreement with its “strategic partners” that they will indemnify or reimburse the bank for credit or fraud losses. Coastal can declare the agreement in default if its partners do not replenish its cash reserve, but the bank is ultimately on the hook for these loans and deposits in the event that their “strategic partners” are unable to pay.

Another gem I found was on p. 66 of the 2023 10-K. It is a table that shows the percentage of charge-offs from the CCBX segment that are covered by the above mentioned “credit enhancements”.

Even with the massive increases in the “credit enhancements” over the last couple of years, the bank has not able to entirely cover the charge offs from the CCBX segment. Yet another red flag.

My reaction after reading about the “indemnification income” is shown in the gif below.

The second portion of the segmented financial information, shown below, brings its home. Even after the huge increases in loans in to supposedly “higher yielding” lines of business, the CCBX segment has not been able to make more money on a net income basis than the Community Bank segment. Seems like Coastal is putting in a lot of work, effort, and probably loads of stress, for a line of business that may not be as good as it thinks.

I had a lot of questions brewing after I read about the “BaaS indemnification income” and through the Segmented Financial Information tables. A lot of them ultimately boil down to the question, “Why?”

Why was the bank so eager to dive into the Fin-Tech lending space through the CCBX segment over the last three years?
Why has the underwriting been so bad?
Why the focus on Consumer and Other loans in the CCBX segment?
Why wasn’t Coastal originating loans in the same areas that CCBX was before 2021?
Why has the bank continued to grow its CCBX segment when, on a net income basis, the Community Bank segment is more profitable?

Possible Value

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