FMAO - Farmers & Merchants Bancorp: Downgrading To Hold And Reducing The Earnings Estimate

2023-08-10 22:02:41 ET

Summary

• I’ve reduced my earnings estimate because I’ve slashed my net interest margin estimate following the first half’s poor performance.
• Loan growth will likely slow down even further. Factors that bode well for loan growth include expansion, commodity prices, and regional job markets.
• The risk level appears low due to small balances of unrealized losses and uninsured deposits.
• The December 2023 target price is close to the current market price. Further, FMAO is offering a decent dividend yield.

Earnings of Farmers & Merchants Bancorp, Inc. ( FMAO ) will most probably dip this year because of pressure on the margin from rising interest rates and deposit migration. On the other hand, loan growth will support the bottom line. Overall, I’m expecting the company to report earnings of $1.70 per share for 2023, down 31% from last year. Compared to my last report on the company, I’ve slashed my earnings estimate because I’ve reduced my net interest margin estimate. The year-end target price is close to the current market price. Therefore, I’m downgrading Farmers and Merchants Bancorp to a hold rating.

Commodity Prices, Unemployment Rates Provide a Positive Outlook on Loan Growth

Although loan growth has decelerated in recent quarters, it is still at a decent level. The loan portfolio increased by 2.8% in size during the second quarter, which beat my expectations.

Going forward, loan growth will likely continue to slow down because higher interest rates will discourage borrowing. However, growth is unlikely to slow too much because of the recent network expansion, which is in full swing. In the last two months, Farmers and Merchants Bancorp has announced the opening of new offices in Downtown Toledo, Ohio , and Oxford, Ohio .

Further, economic factors will support organic growth. Agricultural and Agricultural Real Estate loans made up around 14% of the company’s total loans. Further, Farmers & Merchants Bancorp operates in Ohio, Indiana, and Michigan. Keeping in view the key agricultural products of these states, corn and soybean prices are important determinants of loan demand. As shown below, these agricultural commodity prices are currently on a normal downtrend, but they’re still quite high.

The unemployment rate is another important factor that determines credit demand in FMAO’s markets. As shown below, the unemployment rates in Ohio, Indiana, and Michigan are currently stable at a low level.

Considering these factors, I’m expecting the loan portfolio to grow by 2.0% in each of the last two quarters of 2023. Further, I’m expecting deposits to grow in tandem with loans. The following table shows my balance sheet estimates.

Compared to my last report wherein I projected earnings of $2.41 per share for 2023, I’ve slashed my earnings estimate mostly because I’ve decreased my net interest margin estimate.

Risks Aren’t Worrisome

Due to the following factors, I believe Farmers and Merchants Bancorp’s riskiness is not troublesome.

1. Unrealized mark-to-market losses on the Available-for-Sale (“AFS”) securities portfolio totaled $45.5 million at the end of June 2023. These losses are around 15% of the total equity book value. The equity market value has dipped by 19.9% year-to-date, so 15% of book value isn’t a big deal, in my opinion.
2. Total uninsured deposits were $442.3 million, or 17.9% of total deposits at the end of June 2023. This level isn’t too high as the existing securities portfolio is around 15% of total deposits. Like other banks, Farmers and Merchants Bancorp also has access to funding that it hasn’t yet utilized (FMAO hasn’t disclosed the amount of funding available). Therefore, I believe the uninsured deposits are well covered and don’t present much of a threat in the unlikely case of a deposit run on the bank.
3. The loan portfolio is well-diversified among different classes, from agriculture to consumer real estate. Due to this diversification, the loan book’s credit risk is low.

Downgrading to a Hold Rating

Farmers and Merchants Bancorp is offering a dividend yield of 4.0% at the current quarterly dividend rate of $0.21 per share. The earnings and dividend estimates suggest a payout ratio of 49.5% for 2023, which is above the five-year average of 35%. Nevertheless, I think the dividend payout is safe because paying out half the earnings as dividends is not only manageable, it’s also sustainable. Besides, FMAO is well-capitalized so regulatory requirements do not present a threat to the dividend payments. The company’s total risk-based capital ratio (excluding the capital conservation buffer) stood at 11.88% at the end of June, as opposed to the minimum regulatory requirement of 8.0%.

I’m using the historical price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value Farmers and Merchants Bancorp. The stock has traded at an average P/TB ratio of 1.52 in the past, as shown below.

The stock has traded at an average P/E ratio of around 12.6x in the past, as shown below.

Equally weighting the target prices from the two valuation methods gives a combined target price of $22.1 , which implies a 5.7% upside from the current market price. Adding the forward dividend yield gives a total expected return of 9.7%.

As I have reduced my earnings estimate, my new target price is lower than my previous target price. Considering the updated total expected return, I’m downgrading Farmers and Merchants Bancorp to a hold rating.

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