FRME - First Merchants: Both Deposits And Loans Struggle To Grow

2023-11-04 10:37:30 ET

Summary

• First Merchants released its Q3 2023 financial results, showing a stagnant loan portfolio and improving loan yields.
• The bank's investment portfolio is shrinking, with significant unrealized losses on fixed-rate securities.
• First Merchants aims to increase deposits to fund loan growth, but faces challenges due to rising deposit costs. NII and NIM are declining.

First Merchants ( FRME ) released Q3 2023 last week, and there are both positive and negative aspects to discuss. As of today, this bank is in a difficult moment and is 40% far from its all-time high.

Loan portfolio and investment portfolio

The loan portfolio is worth $12.30 billion and remained almost unchanged from the previous 2 quarters. It is evident that demand for credit is weakening given current interest rates, however, the average loan yield has seen an improvement. As of today it is 6.58 %, 24 basis points higher than the previous quarter and 182 basis points higher than last year. This is impacted by the fact that 66% of loans are variable rate, while only 34% are fixed rate.

The predominance of the portfolio remains geared toward commercial loans, about 75% of total loans. In addition, new/renewed loans in this quarter averaged 7.88%, 58 basis points higher than the previous quarter. So, on the one hand, the demand for credit has shrunk, and on the other hand, the average yield on loans originated is getting higher and higher with each passing quarter. Although the Fed Funds Rate hike seems to have stalled, I would not be surprised if originated loans have an average rate close to 9% in the coming quarters.

In all, at least for the time being, lending at such a high rate has not led to a deterioration in the quality of loans. On the contrary, allowances to loans are improving both from the previous quarter and from last year.

The investment portfolio is currently in a waning phase since it is not among the priorities to increase it. In fact, we can see how quarter after quarter its value is shrinking: today it is worth $3.70 billion. Maturing securities are not being replaced; on the contrary, First Merchants is selling small units worth about $33 million/$347 million YTD on a monthly basis. By the end of 2024, this portfolio is expected to generate about $335 million including maturity and interest and has a duration of 6.6 years.

Since the securities in the portfolio were purchased before the rate hike, the fixed-rate securities are experiencing significant unrealized losses. Adding up AFS and HTM securities, these losses amount to $629.50 million. This is a significant figure since equity is worth just over $2 billion.

Deposits and profitability

Total deposits amount to $14.60 billion, also unchanged from the previous quarter. Of these, 71.50% are insured and non-interest bearing deposits amount to 17%. Increasing deposits remains a primary objective for the time being, as management's intention is to use excess liquidity to make new loans at current market rates. This also relates to why the investment portfolio has been put on the back burner to focus primarily on the loan portfolio. From CEO Mark Hardwick's words during the conference call , there was some optimism about achieving this goal:

I think we're pretty confident in our ability to continue to grow our deposit base to fund our loan growth. And so that mid to higher single digit growth rate of loans for next year, funded primarily out of deposits is what we're focused on.

However, there is one aspect to consider, which is that the increase in deposits must be done judiciously and without giving too high an interest rate.

In Q3 2023, the average cost of deposits increased again and reached 2.32%, an increase of 33 basis points from the previous quarter. Although the Fed Funds Rate has stalled, it is likely that deposit pressure may continue not only in the next quarter, but also in the first half of 2024. So, it will not be easy to increase deposits if money market rates yield more than 5%.

Finally, let us take a look at the NII and NIM. Both are declining due to the rising cost of deposits, and that trend is likely to continue at least until Q4 2023. At that point, CFO Michele Kawiecki expects that early in the year loan growth could mark a turning point.

Well, I think in Q4 with the margin compression that we think we might see, at least a bit of it that we think we'll see, there could still be some pressure on net interest income. I think once we hit that trough, though, and we make a turning point, then we should be able to see some growth. And I think the loan growth that we'll expect to see over the coming quarters will also help offset any rising deposit costs that are left until we see some real deposit pricing stability.

Equity and shareholder remuneration

In terms of capital ratios, First Merchants is well capitalized. However, if we included the unrealized losses of AFS securities, the CET 1 ratio would be only 9.39%. In other words, this bank is well capitalized as long as the unrealized losses do not become realized.

It is for this reason that at least for the time being, the buyback has been put on hold, as it would negatively impact equity just like AOCI. Before purchasing own shares, CEO Mark Hardwick said that a reduction in volatility in the market as well as an improvement in tangible common equity will be needed.

Finally, I would like to show you this image to give you an idea of First Merchants' constancy and my doubts about it.

Since 2012 the track record has been quite positive, in fact they have seen steady improvement in both dividends, EPS, and TBV per share. As of today, this bank is far from the all-time high of about 40% and could be a good opportunity for those who had placed this bank on their watchlist for some time. In any case, keep in mind that these results occurred during a decade with rates close to 0% and with only one recession (the Covid-19 recession) that was very short-lived. The next decade may not be so favorable, and the track record may get worse. For that matter, I suggest you look at the poor performance achieved by First Merchants during the 2008 recession. The image above proposed in Q3 2023 highlights only the upsides achieved after reaching the bottom, but not what happened a few years earlier. Suffice it to say that 2002 EPS was $1.69, 2014 EPS was $1.65: more than 10 years of stagnation.

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