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Playing the Devil’s Advocate


A Report on Synovus Financial (SNV- $1.92): 12/18/09

Usually the act playing the devil’s advocate involves taking a contrarian position. So, in the case of a stock that is
trading at about $2, down from over $30 in 2007, presenting a pessimistic outlook for the stock might not seem
particularly bold or unique. However, Tom Brown from bankstocks.com recently wrote a bullish piece on Synovus
Financial (SNV) that argued pretty persuasively that the bank was undervalued at the current price, based on some
reasonable assumptions about future earnings. Brown also contends that the bank likely has sufficient capital to
survive the credit cycle without diluting shareholder further by issuing shares. While I do not necessarily disagree
with his overall thesis that SNV has the potential to be one of the survivors, based on my analysis of the bank’s
capital position and credit trends I do not agree with Brown’s assessment of SNV’s near term prospects.
Specifically, the data I have analyzed continues to highlight some troubling developments in the bank’s loan book
that could eventually force the company to raise new capital and could impair earnings for many quarters to come.
Clearly, being an investor with a long time horizon, short term issues should not influence my opinion of the stock
as long as I believe the company will make it through alive. Therefore, let me start off by addressing each one of
Brown’s arguments and then close with what I think it all means for the long term.

Point 1: “The worst-performing loan portfolios have begun to shrink. In any major credit cycle,
different loan categories will have vastly different default frequencies and loss severity. For Synovus, the
worst portfolios, both in frequency and severity, have been (by product type) loans to homebuilders and (by
geography) loans in the Atlanta metro area and in Florida.”

Brown is spot on when he points out that the residential construction book, especially in Atlanta and in Florida, has
been SNV’s worst performing portfolio. As of Q3 2009, $507.5M of this $2,513.3M book was classified as
nonperforming. If an NPL ratio close to 24% (up from 19.2% in Q2) sounds high that’s because such a rate would
have been unfathomable just 3 or 4 years ago. Fortunately for SNV, the size of the 1-4 family construction and
development portfolio and its potential impact on earnings has begun to shrink. Specifically, this portion of the book
was down to $2,513.3M ( 9.5% of the total book) in Q3 2009 from $2,963.6 (10.7% of the total book) in Q2. Also,
given how early the southeast portion of the US began to experience the housing bust, it is likely that many of these
construction loans have experienced the bulk of the writedowns they will cumulatively see. However, in my view,
problems with construction loans represent only the first wave of writedowns and losses for SNV and the other
regional banks. The second wave, which consists of prime mortgage defaults, commercial real estate writedowns
and losses on C&I loans, is just starting to play out. In particular, when combined with the lack of consumer credit
and substantial unemployment, the negative derivative impacts of the housing crisis are really starting to impact
other types of businesses and loans. Take a look at the following chart and you can see what I mean:

Q1 2009 Q2 2009 Q3 2009


Net Charge Offs: $246.0 $355.0 $497.0
Non-Accrual:
1-4 Family Construction $231.8 $209.8 $166.6
Other Construction & Land 419.3 548.5 606.9
Total Construction/Land $651 $758.4 $773.6
Farmland 3.8 2.8 2.0
1-4 family Mortgage 131 175.7 192.6
Multifamily 13.5 17.6 12.7
Nonfarm/Non-residential Mortgage 258.3 275.3 397.4
Non-Accrual Tied to Real Estate $1,057.6 $1,229.8 $1,378.3
Total Non Accrual $1,214.7 $1,378.8 $1,469.8
Source: FDIC.gov

I compiled the above data from the FDIC’s website and it only includes loans classified as non-accrual (total
nonperforming assets also includes other real estate owned and loans 90+ days past due and still accruing interest).
Now, the bank has disposed of some underperforming loans and this may be skewing the data a bit, but I believe the
trend is clear. We can see increasing net charge offs (to be addressed more later on) and increasing non-accrual
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loans in the following portfolios: construction, 1-4 family residential mortgage and nonfarm/non-residential
mortgage (commonly known as commercial real estate mortgages). I think this data definitely corroborates what
Brown is arguing in point number one. Non-accrual loans in the 1-4 family construction book were down to
$166.6M in Q3 2009 from $231.8M in Q1 2009. But look at the close to 50% increase in non-accrual loans having
to do with other construction and land. Also look at the dramatic increase in 1-4 family mortgage delinquencies and
in commercial real estate non-accruals. This represents the second wave of delinquencies that I believe are going to
keep credit losses elevated, require SNV to continue to build its reserve, and ultimately require additional capital.

Point 2: “The inflow of new nonaccrual loans will continue to slow.”

I addressed this point above but will say a few more words here. Since the company is on pace to sell $600M in
troubled assets during Q3 and Q4, it is important to look at new additions to non-accruals and not just the change in
balance between one quarter and the next to evaluate whether there has been an increase or decrease in problem
loans. Brown estimates that additions to non-accruals will only be $650M in Q4 2009 versus $756M in Q3 2009.
Apparently, these beliefs were confirmed on his recent trip to visit the management team. Unfortunately, if this does
occur I believe it will only be a temporary reversal based on the fact that while construction NPLs will continue to
decrease, that reduction will eventually be more than offset by new problem loans in other categories.

Also, I am having trouble assessing the impact of this change, but it looks like SNV may have moved the goal posts
a bit in terms of classifying NPLs. From the Q3-2009 10-Q:

“During the third quarter of 2009, Synovus revised its definition of nonperforming loans to exclude accruing
restructured loans. Such loans are not considered to be nonperforming because they are performing in
accordance with the restructured terms. Management believes that this change better aligns our definition of
nonperforming loans and nonperforming assets with the definition used by our peers and therefore improves the
comparability of this measure across the industry. All prior periods presented have been reclassified to conform
to the new presentation… Accruing restructured loans were approximately $193 million at September 30, 2009,
compared to $18 million at June 30, 2009. At September 30, 2009, the allowance for loan losses allocated to
these accruing restructured loans was approximately $29.7 million.” (Emphasis added)

Now, the company does not give a lot of additional info on these restructured loans, but from what the national data
on housing-related re-defaults tell us (up to a 70% rate when modifications only include interest rate changes), these
may be some of the riskiest loans in the portfolio. If all $193M of these loans were classified as NPLs then total
NPLs would increase by 11% and companies allowance to NPL ratio would look even more insufficient.

Point 3: “The level of net chargeoffs should start to decline.”

The first reason that Brown states for a potential decline in NCOs is that he believes that new non-accruals will be
down quarter on quarter. According to Brown, the company takes an immediate 15-20% haircut on non-accrual
loans in the form of a charge off. So, if new non-accruals are down so too will NCOs. Since we obviously have
differing opinions on this I will move on to the next point. Second, in Q3 SNV wrote down existing NPLs by
$135M and Brown makes the valid point that it is unlikely that the bank will take such a large hit on existing bad
loans again in Q4. When you combine cumulative writedowns and specific reserves associated with each loan, SNV
has allowed for a 46% cushion (Brown uses 42% as his figure but the Q3 2009 10-Q claims the number is 46%) that
should be enough to limit significant writedowns in existing NPLs.

However, the company plans to complete its sale of up to $600M in problem assets (including other real estate
owned) by the end of Q4 and that may cause SNV to recognize losses before it would have if it had held onto the
loans. Specifically, in Q3 the company recognized $76M related to charge offs on loan sales. Unfortunately SNV
does not break out what portion of the $339M of assets sold was loans and what portion was OREO so it is hard to
estimate exactly the magnitude of the writedowns on each. However, it is important to note that whatever the
percentage is, it is likely in addition to the initial 15-20% hit the bank takes when a loan gets classified as non-
accrual. Also, since SNV may be unable to sell the most distressed assets, the assets sold in Q3 may have been
somewhat cherry picked and the associated writedowns may not accurately represent the overall losses embedded in
the portfolio. In fact, based on the $600M target of asset sales SNV will likely have to realize additional losses on
the $261M in assets remaining to be sold in Q4 and NCOs may not actually decline at all.
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In any case, under the assumption that SNV is eventually going to have write off existing dodgy assets whether it
sells them or not, a temporary postponement of NCOs in a single quarter should not influence the overall analysis of
the company’s long term value.

Point 4: “The level of OREO writedowns should also start to decline. Synovus had $606 million of credit
expenses in the third quarter, including an unusually high $101 million in OREO expenses. OREO writedowns
should decline for three reasons. First, new nonaccrual loans moving into OREO have been written down to
lower values than in prior periods. Second, the company will be less aggressive in OREO disposition. Finally,
loss content of future OREO dispositions will be lower than in the past because properties being disposed of
now tend to include more income-producing properties and less land than they did before.”

I surmise that Brown is correct on this assumption, barring a huge spike in foreclosure activity in Q4 2009. But, as
pointed out above, if the company is going to eventually have to write down OREO to the lower of cost or fair
value, the timing of the writedowns is not particularly important to someone who wants to buy and hold the stock.
Plus, I am concerned that the number of foreclosures stemming from commercial real estate loans and 1-4 family
mortgage defaults are going to keep OREO costs elevated and negatively impact earnings.

Point 5: “Loan loss reserve building has slowed and will soon stop; reserves will begin to be drawn down
next year.”

“Not only do we expect this to continue but, next year, as more loans are upgraded, we believe the
company will begin to bring its loan loss reserve (3.5% of total loans) down by provisioning less than its
quarterly level of net chargeoffs.”

This is where I think I disagree with Brown the most. The idea that SNV does not have to continue to build its
reserve seems unfounded. Going back to the first chart that shows the persistent increases in non-accrual loans, I
cannot see a justification for SNV solely matching its Q3 provision to net charge offs. A conservative ratio of
allowance for loan losses to nonperforming assets is 100%. This means that for every $1 of NPAs, the bank sets
aside $1 for potential losses. While this may be unnecessarily cautious in some cases, it looks to me like SNV may
be under-reserved. Take a look at the following chart:
Provision for Loan Losses YTD Q3 2009
NCOs $1,098.0 $497.0
Provision $1,418.5 $496.5
Provision to NCO Ratio 129.19% 99.90%

Allowance Q2 2009 Q3 2009


Allowance for Loan Losses $918.7 $918.5
Allowance to NPAs 53.47% 52.56%
Source: Company reports
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As of Q3 2009, the ratio of the allowance to NPAs was only about 52.6%. Keep in mind that one of the reasons this
number did not decrease even further was that SNV sold $339M in troubled assets and subsequently took large
losses on those sales. In particular, new non-accrual loans in Q3 were $756M and the company (on net) did not
increase its reserve accordingly. Even worse, the quarterly provisioning for Q3 did not even cover the NCOs
recognized in that period, a fact that indicates to me that SNV is barely keeping its head above water. These actions
are not indicative of a conservative management team that is being realistic about potential future losses. My theory
is that the bank is actually concerned about its capital levels and does not want reduce its common equity even
further by increasing the allowance for loan losses. Also, under-provisioning allows the company to report higher
earnings (or less negative earnings) than it would otherwise. It is in situations like these that I like to create a pro-
forma valuation for a bank under the assumption that it had an allowance to NPA ratio of 100%:

Q3 2009 Pro Forma B/S Stock Price: $1.92 This table shows what multiple to book and tangible book SNV
Allowance for Loan Losses $918.5 would be trading at if it matched its allowance to actual NPAs.
Total NPA 1747.5
This is a conservative way to evaluate banks, but in the current
economic environment an analysis like this is a necessity. In
Difference -$829.0
comparison to the multiples to stated book and tangible book of
.29x and .30x, respectively, under this scenario the multiples
Stated Total Assets $34,610.50 jump to .47x and .49x. Also, gross loans to tangible equity (a
Stated Net Loan Book $25,413.2 measure of leverage) spikes from 12.2x to 19.9x and the
Tangible Common Equity $2,154 company’s tangible equity to tangible assets (TE/TA: a measure
Common Equity $2,211 of capital sufficiency that I put above all others) drops from
Increased Reserved 829 6.23% to 3.93%. Bank analysts look for TE/TA levels at or
Adjusted TCE $1,325 above 5%, especially for banks that are seeing their loan books
Adjusted CE $1,382 deteriorate. This is a perfect example of how under-
Gross Loans/TE 19.9x
provisioning and not recognizing losses can make a bank look
healthier than it really is. I can’t say for sure that SNV’s
P/TBV 0.49x
management team is being too optimistic, but this analysis
P/BV 0.47x
suggests that (especially given the continued increase in non-
TE/TA 3.93% accrual loans) SNV may be forced to raise new capital if it
wants to have a sufficient buffer against future losses.

“Given our forecast for improving credit, declining credit costs, and modestly improving pre-tax, pre-credit
cost earnings, we expect manageable operating losses and a modest decline in the company’s capital ratios
before they start to sharply improve in the second half of 2010 and in 2011. Under this scenario, we do not
expect a dilutive capital raise!”

In addressing the capital issue, Brown includes a chart that highlights a few of the bank’s capital ratios. However, I
do not put a whole lot of stock in Tier 1 ratios and claims of being “well capitalized.” How many banks were
considered “well capitalized” the day before the FDIC walked in and shut them down? This is precisely why I like
to look at TE/TA and leverage ratios such as Gross Loans/TE to get a handle on capital sufficiency. Based on these
metrics I do not believe SNV currently has strong enough capital levels for potential investors to be comfortable. To
make matters worse, Brown indicates that he expects the capital levels to actually decrease even further, partially
offset by some balance sheet shrinkage and gains from asset sales. Honestly, I am not sure what he is referring to
when he asserts that SNV will realize gains from asset sales. Unless the company is planning on selling off
profitable business lines, it appears that sales of loans and OREO are actually leading to significant losses and
further capital destruction.

Future Earnings Analysis

Now that we have finished assessing the balance sheet, it is necessary to look at future earnings and the income
statement. The truth is, no matter how ugly balance sheet is, if the SNV can survive the cycle (and even if it does
have to raise some more capital) and get back to somewhat normal earnings levels, the stock at the current valuation
may be very attractive. From Brown:

“Assuming the company turns profitable in the third quarter of next year, its initial earnings will be tax-
free. Then after a few quarters of profitability, the company will be able to reverse its deferred-tax asset
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reserve, which today totals $331 million. This would boost the company’s capital ratios by around115
basis points and boost tangible book value by 70 cents per share, or 15%...

Given this [estimated] level of income [$685M], $160 million of “normalized” credit expenses, a full tax
rate, no TARP preferred dividends, and 490 million shares outstanding, we see normalized EPS of 70 cents
per share. Assuming a below-historical normal P/E multiple of 12 times, we see the stock trading between
$8 and $9 over the next two to three years, making it a potential five-bagger from today’s stock price.”

First, I am far from an expert on deferred tax assets and loss carry-forwards, but if what Brown says is correct the
future tax savings could be substantial. I am not sure how to handicap this since it is hard to know what the next few
quarters will look like in terms of profitability. As mentioned above the level of provisioning is a huge factor in
determining whether or not a bank is profitable in a given period. Accordingly, I would rather focus on what SNV
could be worth in a more normal operating environment, given that the company survives this credit cycle. Brown
estimates that normalized EPS are in the $.70 range and if a 12x multiple were applied to those earnings the stock
could be worth between $8 and $9 dollars. On a similar note, here is my analysis based on pre-tax pre
provision/credit losses earnings (eloquently known herein as PTPPE):

Pre Tax Pre Provision Earnings 2004 2005 2006 2007 2008
Net Interest Income $860.7 $965.2 $1,125.8 $1,148.9 $1,077.9
Non Interest Income 1521* 327.4 359.4 389 396.6
Non Interest Expense 1588.4* 646.8 764.5 803.3 986.3
PTPPE $793.3 $645.8 $724.0 $750.3 $624.9
Shares Outstanding 310.3 314.8 324.2 329.9 329.3
PTPPE per Share $2.56 $2.05 $2.23 $2.27 $1.90
Closing Stock Price $28.58 $27.01 $30.83 $24.08 $8.30
P/E Multiple 11.18x 13.17x 13.81x 10.59x 4.37x

Provision for Losses 75.3 82.5 75.1 170.2 699.9


Foreclosed RE Expense 0 0 3.3 15.7 136.7
*Includes revenues and expenses from payment processing that were not present post 2004
Source: Company filings and my calculations

In the above chart I calculate PTPPE by adding net interest and non interest income, subtracting non-interest
expenses and adding back foreclosed real estate expenses. Over the last 5 years the average PTPPE per share was
$2.20 and the average multiple that the stock traded at in relation to that figure was 10.62x (clearly dragged down by
2008 data). The reason I am not trying to estimate EPS like Brown did is because it is very difficult to make any
meaningful assumptions about future credit losses and foreclosed real estate expenses. Just look at the disparity
between the provision as recently as 2006 and the full year provision for 2008. Having said that, it is important to be
careful not to extrapolate the bank’s current issues too far into the future and to make sure to keep in all that the
government might do in the coming years to help boost bank profitability.

Based on my assumption that the company should increase its allowance by about $830M to be safe, to get TE/TA
back up to 5% SNV would have to raise an additional $375M in capital. At $2 a share, that implies an increase in
shares outstanding of 187.5M, bringing the total to somewhere around 520M. From there, assuming a conservative
run rate PTPPE of $625M implies per share earnings of $1.20. If the company ever traded at 10x that amount the
stock could eventually get to $12. Of course, it could take years for a normalized scenario to play out, especially
given my expectations of future credit losses, but the analysis of earnings does indicate that Brown may be on to
something with SNV.

Now, I have to temper the optimism a little bit with the following data. I use a basic guideline for valuing the
appropriate multiple of book value for bank as follows: a bank that earns a return on common equity (ROCE) of
10% should trade at 1x book value and a bank that earns an ROCE of 20% should trade at 2x book value. While
SNV has been able to achieve a strong net interest margin (NIM) over the years, the bank’s ROCE has not been
particularly noteworthy:
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Historical Returns 2004 2005 2006 2007 2008 5 Yr Avg.


NIM 4.22% 4.18% 4.27% 3.97% 3.47% 4.02%
ROCE 17.90% 12.80% 12.50% 9.60% -18.50% 6.86%
ROA 1.90% 1.40% 1.40% 1.10% -1.70% 0.82%
Efficiency Ratio 52.10% 49.80% 51.20% 54.50% 64.90% 54.50%
Source: Capital IQ and my calculations

Specifically, even if the poor results from 2008 are omitted from the data, the average ROCE for SNV over the
boom years of 2004 to 2007 was only 13.50%. This would imply a fair book value multiple of only 1.35x. However,
as is shown below, SNV over that same period traded at much higher multiples to book value:

Historical P/E Average Multiple Historical P/Tang. Book Average Multiple Historical P/B Average Multiple
2004 19.43x 2004 3.91x 2004 3.28x
2005 19.11x 2005 3.97x 2005 3.20x
2006 16.47x 2006 3.50x 2006 2.79x
2007 15.52x 2007 3.15x 2007 2.52x
2008 14.16x 2008 1.15x 2008 0.97x
Current NM Current 0.30x Current 0.29x
5 Yr Avg. 16.94x 5 Yr Avg. 3.14x 5 Yr Avg. 2.55x
Source: Capital IQ and my calculations

I think these lofty, growth-like multiples were indicative of irrational exuberance among investors when it came to
banks. People got caught up in the potential for balance sheet and earnings growth due to all of the population
growth-induced new lending opportunities in the southeast and western portions of the US. But now that balance
sheets and earnings are shrinking, unless you view banking as a no risk, money printing business, it is hard to justify
a bank that can only generate a 13.5% average ROCE during a boom trading at 2.55x book. Thus, this data does not
indicate to me that SNV should go back to trading at 2.5+ times book when the credit environment becomes more
normal.

So, if we apply a fair multiple of 1.35x to an estimate of future book value, we can get a more realistic idea what
SNV may be worth in the coming years. Based on my current fair book value of $1,382M (after adding $830M to
the allowance), adding an additional $375M in equity from issuance of new shares, incorporating a 10% additional
reserve build to account for future losses (meaning that the bumped up reserve will not be enough to last through the
cycle), and taking into account about 520M shares outstanding results in an estimate of book value per around $3.00

Current Adjusted BV $1,381.7


(+) Additional Equity Capital $375.0
(-) Additional Reserve $174.8
Future BV $1,582.0
Shares Outstanding 520
BVPS $3.04
1.35x Multiple $4.11
2.55x Multiple $7.76

These calculations clearly do not entail as much potential upside as the earnings analysis. Even if the stock traded at
the 2004-2008 average multiple of 2.55x, the stock would only be worth about $7.75. Having said that, with the
stock around $2 today and even with the assumption of massive additional dilution, the resulting $4.00 stock price in
a few years still would represent meaningful appreciation.

Therefore, analysis of both the balance sheet and income statement lead to the conclusion that if SNV is able to
make it through the cycle without being sold in a distressed transaction or taken over by the FDIC as a result of
being undercapitalized, shares are likely to trade much higher in the coming years. Unfortunately, this conclusion is
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dependent on a number of assumptions that could prove to be woefully incorrect. First, there is no way to know if
the bank will need to raise capital, how much it will need and how dilutive the share issuance will be based on the
stock price at the time. Next, because of the difficulty in anticipating the direction of unemployment, housing prices
and general economic trends, estimates of future credit losses are likely to be unreliable. Finally, applying historical
rates of returns and multiples in trying to establish intrinsic value is, at best, an imprecise method of valuation.

Furthermore, there are plenty of company-specific risks as well. The bank could have to raise substantially more
capital than I have estimated. The capital markets could be essentially shut down at the time SNV recognizes the
need for additional capital and could subsequently become essentially insolvent. Management does not appear to be
publicly acknowledging the continued deterioration in the loan portfolio or the spike in non-accruals in second wave
categories such as commercial real estate and C&I loans. I fear that that some of the under-provisioning that appears
to be going on is based on the hope that the real estate markets begin to turn around as the economy shows
preliminary, but very tenuous signs of recovery. When combined with my suspicion that the company is loathe to
issue more shares and dilute current shareholders further, this extend and pretend philosophy could be very
dangerous.

In conclusion, an investment in SNV is not for the faint of heart and anyone interested in accumulating shares would
be wise to follow the company very closely. If you cannot already tell, my experience with the management teams
of regional banks has led me to be very distrusting and skeptical of any and all pronouncements or forecasts. The
people who run these banks have an incentive to downplay current and future problems because in the end banking
is business built on trust. Additionally, with the Federal Reserve handing out money and the yield curve so steep, it
is easy to see why banks would try to extend and pretend in an attempt to earn their way out the cycle. Accordingly,
it is more important to monitor the actions of the bank in terms of recognizing losses, adding to reserves and selling
off troubled assets than to rely on the claims of management.

From my perspective, I would be inclined to hold off from investing in SNV until management either acknowledged
the need to raise capital and/or started to increase its reserves again. I believe that current investors are likely to be
substantially diluted through additional share issuance and new investors would be better served being patient.
However, assuming the bank’s franchise has not been severely impaired and SNV ultimately raises enough capital to
make it through the cycle, I think there is a legitimate possibility that the shares could double over the coming years.

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