FMCB - Farmers & Merchants Bancorp: Entering More Difficult Terrain

2023-09-26 12:30:03 ET

Summary

• Farmers & Merchants Bancorp has held up relatively well so far in light of the struggles of its peer group.
• Higher funding costs have yet to really feed through the income statement here, something that probably won't hold in the coming quarters.
• This bank has a very good track record in downturns, and loan loss reserves look prudent for the next one.
• While the valuation has retreated comfortably below its long-run average, the coming quarters aren't going to get any easier for the bank from an earnings perspective.

In a year that has so far not been kind to regional bank stocks, Farmers & Merchants Bancorp (FMCB) has performed relatively well, only falling by around 7% YTD on a total return basis. Sure, its pink-sheet listing has probably helped in that regard, but this under-followed California bank has a good track record when it comes to navigating downturns, and the fact that it is one of not many banks to boast "Dividend King" status (i.e. 50-plus straight years of consecutive dividend growth) is perhaps good evidence of that.

My last piece on FMCB was back in Q4 2022 , at which point I rated it a 'Buy'. Conditions for the industry have become materially tougher since then, and while I don't have any concerns at all about the viability of this bank, it has nonetheless entered more difficult terrain in terms of its near-term earnings environment. This one can still appeal to those with a buy-and-hold type mentality, but I also think the next several quarters will offer better long-term entry points. Thus a Hold rating seems warranted.

Higher Funding Costs Still To Work Through

I've mentioned in previous coverage that one of FMCB's selling points is its core deposit franchise, with non-interest bearing ("NIB") deposits ultimately making up a sizable portion of the funding mix here. Despite recent trends in the wider industry, NIB balances were still in the low-30s percent area here as a portion of total deposits.

Now, funding costs have increased significantly across the industry, but so far FMCB has held up very well. Deposit beta across its total balances (i.e. both interest-bearing and NIB deposits) was still in the low-teens area as of Q2 if my math is right, which would put the bank right at the top-end of its peer group. Deposit beta here hit around 45% in the last hiking cycle, so I do wonder whether the lion's share of the impact of higher funding costs still needs to work its way through the income statement.

Measuring from the start of the year, NIB balances had fallen around 15% up to the end of Q2 - largely offset by higher CD and Savings balances (total deposits were only down around 2.5% over the same period). Net interest margins have likewise been resilient so far, only declining to around 4.27% in Q2 (versus 4.45% for December 2022). Ditto for pre-provision income, which at $31m in Q2 was about flat QoQ - a very good result all things considered and relative to the peer group. That comp does benefit from a loss on the sale of AFS securities (which lowered reported PPOP in Q1), but still, with Q3 now almost done, my main concern approaching results would be that net interest income and PPOP face more downside compared to some of the other regional banks I have covered.

Relatively Well Placed To Meet A Downturn

The impact of higher funding costs on PPOP generation is one of the market's key concerns right now. Another is credit quality, particularly the risks to regional banks from outsized exposure to commercial real estate. CRE (construction, multifamily and other non-owner occupied non-farm nonresidential) is a significant part of the book here, accounting for around 30% of total loans and representing around 2x the bank's tangible book value.

Non-performing loans were still negligible as of Q2 (~0.01% of total loans), as were total delinquent loans (below 0.02% of total loans). Credit quality metrics will worsen from here, but reserving looks quite prudent at a little over 2% of total loans. That figure works out to around twice the level of peak charge-offs recorded during the last big downturn. It's also worth noting that annual PPOP generation remains substantial to absorb potential credit losses, running at around 3.5% of gross loans as things currently stand.

This bank's track record when it comes to performing in downturns is strong, with 2008-2010 annual return on equity readings as follows: 15.23% (2008), 12.33% (2009) and 12.25% (2010). I'd also note that a significant portion of lending here is agricultural (over 20% of total loans), and that does offer a degree of diversity away from the 'regular' business cycle.

Reasonably Priced For Long-Term Investors

FMCB currently trades around the $965 per share mark, putting it around 1.45x tangible book value per share. For long-term investors I'd be inclined to say that represents a good deal. This bank doesn't often trade much lower than that, with its long-run average valuation clocking in at around the 1.7x TBVPS mark.

My main worry is what I set out above - that the earnings environment is only going to deteriorate in the coming quarters. With these shares so far proving resilient versus the peer group, that's something that could translate into a bit more downside in terms of returns over the next few quarters. This remains a fine bank with a great long-term track record, but investors with this one on their watchlist can afford to wait for better entry points. Hold.

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