SRCE - 1st Source Corporation: Bright Topline Outlook Appears Priced In

Summary

• Growth in the specialty finance segment will likely compensate for a slowdown in the community banking segment next year.
• Due to the repricing of some fixed-rate loans next year, the net interest margin will likely continue to expand beyond the end of the up-rate cycle.
• The December 2023 target price suggests a small downside from the current market price. Further, SRCE is offering a modest dividend yield.

Earnings of 1 ^st Source Corporation ( SRCE ) will likely be flattish this year and the next. The growth of specialty finance loans will likely be a key driver of earnings growth next year. Further, earnings will benefit from the lagged repricing of fixed-rate loans. Overall, I'm expecting 1 ^st Source Corporation to report earnings of $4.82 per share for 2022 and $4.87 per share for 2023. Compared to my last report on the company, I've raised my earnings estimates for both years as I've revised my margin and loan estimates. Next year's target price is quite close to the current market price. Therefore, I'm downgrading 1 ^st Source Corporation to a hold rating.

Loan Growth To Slow Down To The Historic Rate

1 ^st Source Corporation’s loan growth continued to gather pace in the third quarter, which positively surprised me. The portfolio grew by 3.8% in the third quarter, leading to 9-month growth of 7.8% or 10% annualized.

Around half of 1 ^st Source Corporation’s loans are in the community banking segment while half are in specialty finance. The outlook for community banking loans isn't too bright because of the high-interest rates. Residential mortgages are especially vulnerable to borrowing costs as home buyers can delay purchases. On the other hand, the outlook for specialty finance is better. This segment includes loans for aircraft, trucks, etc.; therefore, their demand depends more on economic activity than on costs that can be passed on. For specialty finance loans, the Purchasing Managers Index ("PMI") is a good gauge of demand. The manufacturing PMI index is still in the expansionary territory (above 50), though it's barely hanging on. Services PMI is in better shape, as shown below.

Another reason why I'm hopeful about the specialty finance segment is the extraordinary labor market. As shown below, the unemployment rate hasn't been this low in decades.

Within the specialty finance segment, I'm particularly positive about solar loans, which made up about 6% of total loans at the end of September 2022, according to details given in the 10-Q filing . I'm expecting these loans to continue to surge in the coming quarters as the economy continues to shift towards sustainable and renewable energy.

Considering these factors, I'm expecting loan growth to decline to the lower end of the historical range over the next few quarters. I'm expecting the loan portfolio to grow by 2% in the last quarter of 2022, leading to full-year loan growth of 10%. For 2023, I'm expecting the loan portfolio to grow by 5%. In my last report on 1 ^st Source Corporation, I estimated loan growth of 5.9% for 2022 and 4.1% for 2023. I've raised my loan growth estimates because of the performance in the third quarter which beat my expectations. The performance has made it evident that I underestimated the management’s capabilities before.

Meanwhile, I'm expecting deposits to grow in line with loans. Other balance sheet items will likely trail loan growth. The following table shows my balance sheet estimates.

In my last report on 1 ^st Source Corporation, I estimated earnings of $4.58 per share for 2022 and $4.68 per share for 2023. I've raised my earnings estimate as I've revised upwards both my loan and margin estimates.

My estimates are based on certain macroeconomic assumptions that may not come to pass. Therefore, actual earnings can differ materially from my estimates.

Downgrading To A Hold Rating

1 ^st Source has been increasing its dividend every year since 2017. Given the earnings outlook, I’m expecting the company to increase its dividend by $0.02 per share to $0.34 per share in the third quarter of 2023. The earnings and dividend estimates suggest a payout ratio of 27% for 2023, which is close to the five-year average of 30%. Based on my dividend estimate, 1 ^st Source is offering a forward dividend yield of 2.3%.

I’m using the historical price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value 1 ^st Source. 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 $55.1 , which implies a 3.3% downside from the current market price. Adding the forward dividend yield gives a total expected return of negative 1.0%.

In my last report, I determined a target price of $54.4 for December 2022 and adopted a buy rating. Since then, the stock price has rallied, leaving a small downside to next year's target price. Therefore, I'm now downgrading 1 ^st Source Corporation to a hold rating.

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