SRCE - 1st Source Corp.: Moderate Topline Growth To Partially Counter Provision Normalization

• Loan growth will likely remain at a moderate level through the end of 2023.
• Neither the loan portfolio nor the deposit book is highly rate-sensitive. Therefore, the margin will expand only moderately as interest rates surge.
• Despite headwinds, provisioning will remain at a normal level through the end of 2023 thanks to the high loan loss reserves.
• The December 2022 target price suggests a moderately high upside from the current market price. Further, SRCE is offering a decent dividend yield.

Earnings of 1st Source Corp. ( SRCE ) will likely dip this year mostly on the back of provision normalization. On the other hand, moderate loan growth will likely support the bottom line. Further, some margin expansion will support earnings. Overall, I'm expecting 1st Source Corporation to report earnings of $4.58 per share for 2022, down 3% year-over-year. Compared to my last report on the company, I've revised upwards my earnings estimate as I've increased both my loan and margin estimates following the second quarter’s extraordinary performance. For 2023, I'm expecting 1st Source to report earnings of $4.68 per share, up 2% year-over-year. The year-end target price suggests a moderately high upside from the current market price. Based on the total expected return, I'm maintaining a buy rating on 1st Source Corporation.

Loan Growth Deceleration Likely

1st Source Corporation's loan book grew by a strong 2.9% in the second quarter of 2022, or 11.7% annualized, which beat my expectations. Given the company's historical trend, the second quarter’s growth was extraordinarily high.

Half of 1st Source Corporation’s loans belong to the specialty finance segment (aircraft, trucks, construction equipment) while the other half belongs to the community banking segment (mostly small business loans). Therefore, the purchasing managers' index is a good gauge of product demand. Although it has been on a downtrend so far this year, it is still indicating expansion in manufacturing and services segments.

The unemployment rate is another appropriate indicator for credit demand. The company mostly operates in northern Indiana and southwest Michigan. While Indiana has a hot labor market with a very low unemployment rate, Michigan's unemployment rate is trailing the national average. Nevertheless, both states have unemployment rates that are near record lows from a historical perspective.

However, some of 1st Source Corporation's business sub-segments, especially renewable energy financing, are nationwide. Therefore, the U.S. unemployment rate is also an important metric to determine future credit demand.

Considering the mixed economic review, I'm expecting loan growth to decline from the second quarter’s level and remain slightly below the historical mean through the end of 2023. I'm expecting the loan book to grow by 1% every quarter (4% annualized) till the end of next year. Compared to my last report on the company, I've maintained my loan growth estimate for the second half of 2022 and full-year 2023. However, as loan growth surpassed my expectation in the second quarter of 2022, I've revised upward the full-year estimate for this year.

Meanwhile, I'm expecting other balance sheet items to grow mostly in line with loans. However, I'm expecting the equity book value to dip this year despite my expectations of positive retained earnings as discussed below. I'm expecting equity book value to dip because the rise in interest rates will build up unrealized losses on the available-for-sale debt securities portfolio. These losses will bypass the income statement and flow directly to the equity account through other comprehensive income.

The following table shows my balance sheet estimates.

In my last report on 1st Source Corporation, I projected earnings of $4.19 per share for 2022. I've revised upwards my earnings estimate because I've tweaked upwards both my loan and margin estimates following the second quarter’s performance.

Actual earnings may differ materially from estimates because of the risks and uncertainties related to inflation, and consequently the timing and magnitude of interest rate hikes. Further, a stronger or longer-than-anticipated recession can increase the provisioning for expected loan losses beyond my estimates.

Maintaining a Buy Rating

1st Source Corporation has a 34-year long history of annual dividend increases. Therefore, it's very likely that the company will increase its dividend in early 2023. I'm expecting a $0.02 per share hike in the dividend level in the third quarter of 2023, which will bring total dividends to $1.32 per share for the full year. My dividend and earnings estimates suggest a payout ratio of 28% for 2023, which is in line with the last five-year average of 30%. My dividend estimate suggests a dividend yield of 2.7%.

I’m using the historical price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value 1st Source Corporation. The stock has traded at an average P/TB ratio of 1.54 in the past, as shown below.

The stock has traded at an average P/E ratio of around 12.7x in the past, as shown below.

Equally weighting the target prices from the two valuation methods gives a combined target price of $54.4 , which implies a 10.5% upside from the current market price. Adding the forward dividend yield gives a total expected return of 13.1%. Hence, I’m maintaining a buy rating on 1st Source Corporation.

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