AROW - Arrow Financial: Revenue Outlook Remains Bright
Summary
- Loan growth will slow down due to high interest rates. However, strong job markets will likely buoy loan growth.
- As AROW’s liabilities reprice faster than assets, the margin will benefit from the rising rate environment with a lag.
- High inflation and tight labor markets will likely pressurize salary expenses.
- The December 2023 target price suggests a small upside from the current market price. Further, AROW is offering a modest dividend yield.
Earnings of Arrow Financial Corporation (AROW) will receive a boost from New York's strong job markets and the lagged effect of interest rate hikes. On the other hand, growth in salary expenses will limit the increase in earnings. Overall, I'm expecting Arrow Financial to report earnings of $3.00 per share for 2022 and $3.30 per share for 2023. Compared to my last report on the company, I have slightly reduced my earnings estimate for 2023 as I've raised my non-interest expense estimate. Next year's target price suggests a small upside from the current market price. Based on the total expected return, I'm upgrading Arrow Financial Corporation to a buy rating.
New York's Healthy Job Market to Sustain Loan Growth
Arrow Financial Corporation’s loan growth remained near the historical average during the third quarter of 2022. Going forward, loan growth is likely to slightly slow down because of high interest rates. The residential mortgage segment is likely to be hit the most as demand in the segment is dependent on borrowing costs and home prices. Residential mortgages are an important component of Arrow’s loan book as they made up around 36% of the total loan portfolio at the end of September 2022.
On the other hand, regional economic dynamics will likely support loan growth. Arrow Financial operates in the state of New York, where the recent trend of economic activity is a bit shaky. Nevertheless, the trend line is upward-sloping, as shown below.
Further, New York's labor market is quite strong, which is a positive signal for future credit demand. The unemployment rate for the state of New York (excluding New York City) is near record lows, as shown below.
Considering these factors, I'm expecting the loan portfolio to grow by 2.0% every quarter till the end of 2023. This will lead to loan growth of 12% for 2022 and 8% for 2023. Meanwhile, I'm expecting other balance sheet items to grow somewhat in line with loans. The following table shows my balance sheet estimates.
| FY18 |
| FY19 |
| FY20 |
| FY21 |
| FY22E |
| FY23E |
| Income Statement |
| Net interest income |
| 84 |
| 88 |
| 99 |
| 110 |
| 120 |
| 136 |
| Provision for loan losses |
| 3 |
| 2 |
| 9 |
| 0 |
| 4 |
| 4 |
| Non-interest income |
| 29 |
| 29 |
| 33 |
| 32 |
| 32 |
| 32 |
| Non-interest expense |
| 65 |
| 67 |
| 71 |
| 78 |
| 83 |
| 93 |
| Net income - Common Sh. |
| 36 |
| 37 |
| 41 |
| 50 |
| 50 |
| 55 |
| EPS - Diluted ($) |
| 2.43 |
| 2.50 |
| 2.64 |
| 3.10 |
| 3.00 |
| 3.30 |
| Source: SEC Filings, Author's Estimates (In USD million unless otherwise specified) |
In my last report on Arrow Financial, I estimated earnings of $3.00 per share for 2022 and $3.35 per share for 2023. I have tweaked all line items following the third quarter’s results, but my updated earnings estimate for 2022 is barely changed from my previous estimate. This is because the small changes in the line items cancel each other out. My updated earnings estimate for 2023 is slightly below my previous estimate as I've raised my non-interest expense estimate.
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.
Upgrading to a Buy Rating
Arrow Financial is offering a dividend yield of 3.1% at the current quarterly dividend rate of $0.27 per share. The earnings and dividend estimates suggest a payout ratio of 33% for 2023, which is below the five-year average of 41%. Therefore, there is room for a dividend hike. Nevertheless, I’m not expecting any change in the dividend level as Arrow doesn’t change its dividend payout often.
I’m using the historical price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value Arrow Financial. The stock has traded at an average P/TB ratio of 1.73 in the past, as shown below.
| FY18 |
| FY19 |
| FY20 |
| FY21 |
| Average |
| TBVPS - Dec 2023 ($) |
| 20.4 |
| 20.4 |
| 20.4 |
| 20.4 |
| 20.4 |
| Target Price ($) |
| 31.2 |
| 33.3 |
| 35.3 |
| 37.3 |
| 39.4 |
| Market Price ($) |
| 34.5 |
| 34.5 |
| 34.5 |
| 34.5 |
| 34.5 |
| Upside/(Downside) |
| (9.4)% |
| (3.5)% |
| 2.4% |
| 8.3% |
| 14.3% |
| Source: Author's Estimates |
The stock has traded at an average P/E ratio of around 12.4x in the past, as shown below.
| FY18 |
| FY19 |
| FY20 |
| FY21 |
| Average |
| EPS 2023 ($) |
| 3.30 |
| 3.30 |
| 3.30 |
| 3.30 |
| 3.30 |
| Target Price ($) |
| 34.4 |
| 37.7 |
| 41.0 |
| 44.3 |
| 47.6 |
| Market Price ($) |
| 34.5 |
| 34.5 |
| 34.5 |
| 34.5 |
| 34.5 |
| Upside/(Downside) |
| (0.2)% |
| 9.4% |
| 19.0% |
| 28.6% |
| 38.2% |
| Source: Author's Estimates |
Equally weighting the target prices from the two valuation methods gives a combined target price of $38.1 , which implies a 10.7% upside from the current market price. Adding the forward dividend yield gives a total expected return of 13.8%. In my last report, I adopted a hold rating with a target price of $37.4 for December 2022. Based on the new target price for 2023 and the dividend estimate, I’m upgrading Arrow Financial Corporation to a buy rating.
For further details see:
Arrow Financial: Revenue Outlook Remains Bright