ASB - Associated Banc-Corp Worth Watching As It Prudently Manages Growth

Summary

• Associated Banc-Corp had a good fourth quarter, with revenue and pre-provision profits coming in above expectations on strong earning asset yield improvement.
• Net interest margin has likely peaked, and deposit costs are a definitely watch item, but Associated seems well-placed for strong pre-provision growth in 2023.
• The growth outlook for 2024 is more uncertain, but I like management's plan to target further commercial lending growth in Chicago and Minneapolis and focus more on client experience/satisfaction.
• Associated isn't wildly undervalued but does offer upside toward the high-$20s as it delivers on growth and sentiment improves.

Writing about Associated Banc-Corp ( ASB ) back in October, I said that while I saw value in this underfollowed, growing Upper Midwest bank, sentiment was likely to be a headwind a while longer. And so it has been - the shares have basically tracked the broader regional bank group, despite a good set of results in Q4'22, including above-average loan growth, good pre-provision loan growth, and a modestly below-average cumulative deposit beta.

Operating conditions are going to get more challenging from here. Net interest margin has likely peaked and credit costs are going to head higher. While 2023 should be a strong year for pre-provision growth as the bank rides 2022's tailwinds, 2024 could be more challenging. Still, I like the growth plan here, and I don't think the shares are fully valued for what I think can be 6% long-term core earnings growth. Sentiment is still a risk, but I believe the Fed is closing in on the end of the tightening cycle and these shares could work better in 2023.

Strong Earning Asset Leverage Drives Better-Than-Expected Growth In Q4

Associated's fourth quarter results looked pretty good on balance, with better loan growth, better spread margin, and good cost control. The outlook has some spots on it, which I'll discuss, but I think Associated still goes into 2023 looking better than average.

Revenue rose 32% year over year and 7% quarter over quarter, beating expectations by more than $0.06/share. Net interest income rose 54% yoy and 9% qoq, beating by $0.07/share, with net interest margin up 91bp yoy and 18bp qoq to 3.31% (beating by 12bp) and earning assets down about 3% sequentially.

Non-interest income declined 20% yoy and almost 2% qoq, missing by about $0.005/share, with weaker capital markets (down 27% qoq) and service charges (down 7% qoq) driving much of this.

Operating expenses rose about 9% yoy and 4% qoq and technically missed by a bit, but with the beat on revenue, the efficiency ratio (54.9%, 190bp better qoq) was 170bp better than expected. Pre-provision profits rose 78% yoy and almost 12% qoq, beating by $0.06/share. Provisioning was a little higher than expected, but that pre-provision beat largely fell through to the bottom line.

It Gets Harder From Here

Associated has benefited from above-average earning asset beta (a cumulative loan beta of almost 59% and earning asset beta of 51%) and a shorter-duration loan portfolio (asset-backed finance, equipment finance, and auto lending) that has seen loans reprice faster than for some banks. With that, loan yields improved 207bp yoy and 87bp to 4.93%.

At the same time, the company's efforts over the past years to improve its core deposit base and reduce its reliance on more expensive wholesale funding have paid off. Deposit costs rose 78bp yoy and 47bp qoq to 0.83%, and the cumulative beta of 21.5% compares well to many similarly-sized banks.

Unfortunately, it's not going to get any better. The loan/deposit ratio is nearly 100%, and while non-interest-bearing deposit retention has been pretty good (down 5.6% qoq on an end-of-period basis), the bank is still going to need to tap into more expensive funding sources to fund the above-average 7% to 9% loan growth it expects in 2023 (the average comparable bank is looking for around 6% loan growth).

With that, and like most banks this quarter, net interest income growth expectations for 2023 come down, from about 19% going into the quarter to 15% to 17% now. I would also note that the bank is actively reducing its asset sensitivity - using swaps to shield downside risk on rates, while also limiting future upside.

In addition to spread compression, I expect rising credit costs. Overall, the credit metrics remain good, with non-performing loans down 4% sequentially (0.39% of loans versus 0.52% last year and 0.42% last quarter), and charge-offs likewise remain quite low. Certain categories, namely indirect auto, are eroding more quickly, though, and management is backing off for the time being. Associated isn't the only bank to step back from auto at this point in the cycle, as Citizens ( CFG ) is now running down its auto lending in a pretty meaningful way.

Paths To Growth

Management has been executing fairly well on its growth initiatives. Commercial lending, asset-backed lending and equipment finance, and indirect auto were previously cited as growth priorities by management, and two of the three exceeded management's 2022 goals - auto would have as well if not for the changing in market conditions (increasing credit stress).

Looking ahead, I continue to expect management to prioritize commercial lending growth (C&I, CRE, and ABL/equipment finance), with further targeted expansion into major nearby markets like Chicago and Minneapolis. Management is also looking to target more of the mass-affluent market with new products and marketing efforts, and I expect to see a great emphasis now on customer satisfaction-oriented projects like product innovation and technology.

With a large portion of Associated's in-footprint large bank competitors more focused on markets in the Southeast, California, and Texas, I do think there is an opportunity here for Associated to gain share through a greater focus on high-touch service and a willingness to lend to businesses that are too small to really move the needle for banks like Bank of America ( BAC ), Bank of Montreal ( BMO ), and U.S. Bancorp ( USB ).

The Outlook

I expect above-average pre-provision profit growth in 2023 (around 20%), but I do have some concerns that 2024 could slow significantly as the rate and credit cycle works its way through the income statement. Clearly, a lot depends on how this economic slowdown progresses, particularly since Associated does a lot of lending to manufacturing clients.

Longer term, though, I believe Associated can gain share and grow core earnings at a 6% rate, helped by loan share growth, quality core funding, and good underwriting and augmented with more service-based fee income. Operating efficiency is already pretty good, and with management focusing on limiting expense growth (limiting/cutting spending without a clear tie to future growth), I'm not worried about operating leverage.

Discounted core earnings suggest a worthwhile upside from here, as do shorter-term ROTCE-driven P/TBV and P/E. On the former, an ROTCE a little below 13% in FY'24 supports a P/TBV multiple of 1.5x (a fair value close to $26.50) while 10.5x my 2023 EPS estimate drives a fair value a little above $27.

The Bottom Line

This is likely a "hurry up and wait" story, as I don't think the Street will care much about Associated until there's more confidence that the Fed is done and maybe some insight into what 2024 will look like. I think the wait could be worthwhile, though, as I do see this as an overlooked, underfollowed, and undervalued bank with a credible "blocking and tackling"-type growth plan.

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