AROW - Arrow Financial: Despite Its 60% Return Since September The Stock Remains Reasonably Valued

2023-12-08 15:25:49 ET

Summary

• Arrow Financial has outperformed the S&P 500 by an impressive margin, with a total return of 60% in less than three months.
• The stock remains reasonably valued and analysts expect strong earnings growth next year.
• Investors should hold the stock for an additional potential 10% capital gain before considering taking profits.

Less than three months ago, I recommended purchasing Arrow Financial ( AROW ) for its extremely cheap valuation and its 10-year high dividend yield of 6.2% back then. Since my article, the stock has offered a total return of 60% and thus it has outperformed the S&P 500, which has gained 7%, by an eye-opening margin. After such a steep rally, many investors will be tempted to take their profits. However, the stock remains reasonably valued in my view. Therefore, the shareholders should probably hold the stock for an additional 10% capital gain before they take their profits and look elsewhere for attractive returns.

Business overview – the reasons behind the 60% rally

Arrow Financial is a multi-bank holding company based in Glen Falls, New York. It incurred a fierce sell-off during the first nine months of this year for three major reasons. First of all, the stock was hurt by the extremely negative market sentiment over regional banks after the bankruptcy of Silicon Valley Bank, Credit Suisse and First Republic.

However, as I mentioned in the previous article, Arrow Financial is completely different from the banks that failed. It has numerous small retail depositors and hence it is extremely unlikely to incur a bank run, particularly given its highly profitable business model. In the second quarter, the bank reported flat deposits. Even better, in the third quarter, the bank grew its deposit base 6% sequentially, from $3.5 billion to $3.7 billion. Moreover, it grew its loans 9%, to a new all-time high of $3.1 billion, and the ratio of net charge-offs to average loans decreased from 0.07% to 0.05%. These metrics certainly reflect a healthy business momentum.

Another concern of the market over regional banks is the impact of 16-year high interest rates on their deposit cost and hence on their net interest margin. However, Arrow Financial has proved resilient to this headwind. Its cost of deposits increased in the third quarter, as competition among banks for deposits continued to heat up. Nevertheless, the net interest margin of the bank contracted only slightly, from 2.61% in the previous quarter to 2.53%. Given also the aforementioned strong growth of loans, net interest income slipped only 1.6%. Moreover, the company reduced its non-interest expense and its provisions for loan losses and thus it grew its earnings per share 31%, from $0.35 to $0.46, thus exceeding the analysts’ consensus by $0.13.

The other major reason behind the extremely cheap valuation of the stock a few months ago was a delay in the release of the earnings report of the first quarter. A delay in the reporting of financial results sometimes raises a red flag about the reliability of the results of a company. Arrow Financial did not reveal the reason behind that delay. However, as I mentioned in the previous article, the delay was probably caused by a change in the CFO position; the new CFO probably needed some extra time to make sure that the report was accurate. Indeed, the company has reported its results for the second and third quarter without any delays. Therefore, this risk factor probably belongs to the past.

To cut a long story short, the depressed valuation of Arrow Financial until September had resulted from the extremely negative market sentiment over regional banks, fears about the impact of 16-year high interest rates on its net interest margin and the delay of the earnings release for the first quarter. The bank has proved all these concerns overblown in the last two quarters.

Even better, analysts expect Arrow Financial to recover strongly from the downturn of regional banks this year and grow its earnings per share from $1.82 this year to $2.60 in 2024, just 9% off the earnings per share of $2.86 in 2022.

Valuation

When I wrote the previous article, Arrow Financial was trading at an extremely low forward price-to-earnings ratio of 7.4x. That earnings multiple was 47% lower than the 10-year average price-to-earnings ratio of 13.9x of the stock. The extremely cheap valuation back in September makes it easy to understand the reason behind the 60% rally of the stock within such a short period.

Despite its rally, the stock has not become overvalued. It is currently trading at only 10.4 times its expected earnings in 2024. While the stock is not as attractive as it was three months ago, it is still reasonably valued. Therefore, I advise investors to wait for an additional capital gain of 10%, until the stock approaches the technical resistance of $30. At that point, it will be trading at 11.5 times its expected earnings in 2024 and hence it will be less attractive.

Notably, analysts have raised their estimates for the earnings per share of Arrow Financial in 2024 by 12.5% in the last three months, given the positive business momentum of the bank and the elimination of the aforementioned fears. Therefore, it is possible that analysts raise their estimates further in the upcoming months. Nevertheless, given the exceptionally steep rally of the stock and its fairly reasonable valuation at the price of $30, I believe investors should probably take their outsized profits around $30 and look elsewhere for attractive returns.

Dividend

When Arrow Financial was trading at $17, in late September, it was offering a 10-year high dividend yield of 6.2%. Due to the rally of the stock, the dividend yield has decreased to 4.0% but it remains above the historical average yield of the stock.

Moreover, Arrow Financial has a solid payout ratio of 52% . Even better, if the company meets the analysts’ estimates next year, its payout ratio will improve to 42%. It is also worth noting that the bank raised its dividend for 27 consecutive years until it froze its dividend this year. It thus maintained one of the longest dividend growth streaks in the financial sector. Overall, given the healthy payout ratio of the bank and its positive business momentum, its dividend has a meaningful margin of safety.

Final thoughts

Arrow Financial has rewarded to the extreme the investors who remained focused on the fundamentals and the remarkably cheap valuation of the bank when the market sentiment was extremely negative. Nevertheless, the stock remains reasonably valued. Therefore, as investors can reasonably expect an additional 10% capital gain (for a total return of nearly 80%, including dividends), the rating of the stock is lowered from “buy” to “hold”. On the other hand, whenever the stock approaches the technical resistance of $30, investors should probably take their profits. Such a steep rally is extremely rare and hence it will be a shame to let the outsized profits partly evaporate in the event of an unexpected downturn.

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