HTBK - Heritage Commerce: Significantly Oversold Following The U.S. Regional Bank Crisis

2023-06-27 11:39:42 ET

Summary

• Heritage Commerce remains oversold compared to its peers due to the US regional banking crisis, making it a potential long-term value recovery play.
• Despite the downturn in HTBK's stock, the bank has shown minimal unrealized losses on the balance sheet and a strong capitalization position.
• Management insiders have been buying shares of HTBK, indicating their positive outlook on the stock, and sell-side analysts are targeting a potential uplift of 33% from the current price.

Investment Thesis

I believe that Heritage Commerce Corp (HTBK) is oversold year-to-date compared to bank peers following the regional banking crisis in March, and is worth a long-term value recovery play. The collapse of regional banks such as Silicon Valley Bank was primarily due to heavy unrealized losses on balance sheet securities, which HTBK has managed to avoid, as per the company's Q1 23 press release . As a result, HTBK's stock should be trading at much higher prices, especially when considering their unaffected financial results.

Company Summary

Heritage Commerce Corp is the holding company of Heritage Bank of Commerce, based in the San Francisco Bay area, and servicing retail and commercial customers. The bank offers savings and checking accounts, certificates of deposit, money market accounts, commercial and real estate loans, and working capital factoring. Unsurprisingly, the bank has been affected by the wider regional banking crisis in the US, following the Federal Reserve's aggressive trajectory of monetary tightening to combat high and persistent inflation.

Outlier vs. Peers

Despite the strong financial fundamentals discussed further below, the stock price has suffered year-to-date. HTBK was trading at ~$13 in January, dropping sharply to a low of just under $7 following the fall-out of the collapse of regional banks such as Silicon Valley Bank ( SVB ), Signature Bank ( SBNY ), and First Republic Bank ( FRCB ). The subsequent period saw wide-spread selling across peer banks, as the market questioned which bank would be the next to fail. HTBK has recovered slightly, trading back around the $8-9 mark in recent weeks. Heritage is in over-sold territory, especially when comparing its performance to benchmarks such as the KBW Regional Banking Index, illustrated in the normalized chart below. The KBW Index is down ~26% year-to-date, whilst HTBK is down ~36% in the same period. Looking further back, HTBK has either outperformed or at least tracked the KBW Index in previous years. I expect this divergence to narrow in the coming periods and for the stock price to trend back upwards, as the discount is no longer warranted now that the risk of unrealized losses and wider banking stress has faded.

The market was correct in questioning whether all regional banks had a similar level of balance sheet mismanagement as SVB and co. The Fed's rapid increase in rates in the last year reduced the value of the banks' balance sheet investments, and in the case of SVB, resulted in nearly $16 billion in unrealized losses , which surpassed its equity value. However, HTBK should not be placed in the same bucket and should be trading closer to its benchmark peers. As of March 31, HTBK's unrealized losses on their securities portfolio was only $90 million , accounting for 10% of total shareholders' equity. As per their financial commentary, the fair value is expected to recover as securities approach maturity, and the bank have had no trigger to lead to consider selling these assets and recognizing a loss.

In addition, the concerns around further bank failures have been quelled thanks to the Fed's "Bank Term Funding Program", which makes additional funding available to banks by offering loans, which take Treasury, agency, and MBS securities as collateral. Importantly, these assets are valued at par, even if they are sitting in an unrealized loss position. This avoids any runs on liquidity or panic selling of balance sheet securities to shore up funding, and ultimately repeating the example of SVB. As a result, any balance sheet or liquidity concerns around HTBK should evaporate and the stock warrants an uplift.

Financial Results

Despite the downturn in HTBK's stock, the bank has shown solid fundamentals and positive financial results, which justify a valuation that is closer to the pre-March madness.

Thanks to the higher interest rate environment, HTBK posted Net Interest Income of $179.9 million FY 2022 , up 23% from the prior year. Overall Revenues rose 19% in the same period to $189.2 million, and Net Income increased an impressive 40% to $66.6 million. More recently, Net Interest Income, Revenues, and Net Income in Q1 23 remained relatively in-line with the prior results of Q4 22. Looking forward, revenues are forecasted to reach ~$205 million in FY 2023. None of these results signal a bank that warrants a significant discount to peers and that should be underperforming the benchmark.

Due to the positive and stable fundamentals and solid management, the bank has been able to pay consistent dividends, currently boasting at a Dividend Yield ((TTM)) of 6.30% , which is significantly higher than the sector median of 4.74%. This represents a significant source of passive income for shareholders, which adds another attractive element to this stock.

Valuation

We can analyze HTBK's multiples versus its industry peers in order to further confirm that the stock is undervalued at current levels.

The Price-to-Book (P/B) Ratio looks at the firm's market capitalization to its book value, calculated by dividing the company's current stock price by its book value per share. This ratio is often favored by analysts over the Price-to-Earnings Ratio when analyzing banks and financial stocks, one reason being that these companies often have significant liabilities that they use to fund their operations. The P/B Ratio incorporates the assets and liabilities of a bank, whilst the P/E Ratio focuses on earnings and ignores the balance sheet items. Looking at HTBK versus the Financials sector peers selected by Seeking Alpha, it is undervalued from a P/B Ratio perspective both on a Trailing Twelve Months and Forward-Looking basis. The P/B Ratio ((TTM)) currently sits at 0.78 , at a discount of 22% to the sector median. When looking at the P/E Ratio (GAAP TTM), HTBK is also at a discount of ~24% to its peers.

The stock's EPS estimate for FY 2023 is 1.18, which if we apply to the sector median P/E Ratio (GAAP FWD) of 8.99, it implies a target price of $10.61 for HTBK, representing a ~29% uplift from the current price. This figure compares closely to the forecast return potential implied by the Bloomberg Analyst Survey highlighted earlier.

Given the regional banking risks, another concern from investors to try justify lower bank stock prices is around capitalization and the ability to withstand a stressed scenario. However, when looking at the Bloomberg Relative Valuation screen and selecting North American Regional Banks as the peer group, we can see that HTBK is positioned favorably in the key capital ratios and also boasts a very low amount of Non-Performing Loans versus peers, which should act as a pillar of strength in the event that these smaller banks face tougher conditions in the coming quarters. Tier 1 Common Capital Ratio measures the bank's core equity capital compared to its total risk-weighted assets, indicating the bank's financial strength. As per Bloomberg, HTBK's ratio of 12.70% sits higher than the peer median, suggesting that the bank should be well positioned to withstand financial stress and remain solvent, and again justifies a higher fair value for the stock.

A final important bank specific metric to analyze is the Loans to Deposits ratio, which is used to assess a bank's liquidity risk position. Once more, HTBK is well positioned and has a lower figure than the sector median, indicating that the bank has more reserves available and a more stable funding base for unforeseen contingencies.

Management Buying Stock On The Cheap

I can see further justification that the stock is undervalued whilst analyzing the transactions of the Management Insiders. Looking at the year-to-date data presented on the Bloomberg Insiders page, the vast majority of the transactions have been buy operations, as key staff have increased their shareholdings. This implies that management have a bullish outlook on their own stock and view it as undervalued, and willing to bet money on it.

Shareholder Resilience

On the investor side, I can infer that sector wide concerns have not materialized in HTBK selling pressure from the major shareholders, which strengthens my outlook that a rebound is due for the stock. Within the top 10 investors in the Bloomberg Historical Holdings page, large names such as BlackRock, JPMorgan, and State Street, have actually increased their stakes to date. This should act as a vote of confidence for retail investors considering a value play on HTBK and help reassure that generic balance sheet and capitalization concerns are overstated at current levels.

Bullish Analyst Forecasts

A final factor on my HTBK stock checklist is the view of the sell-side community. A Bloomberg survey of research analysts at banks and brokers reinforces my assessment that HTBK is well oversold, as all respondents have issued a "BUY" rating. As per the below extract, the average of their 12-month estimate target prices comes out at $11 for the stock, representing a forecast return potential of ~33% based on the current price level.

Risks

Despite the positive outlook above, the bank is still exposed to macro headwinds that should be highlighted when considering an investment in this stock.

There is a distinct lack of geographic diversification in the bank's activities, due to their exclusive focus on the Californian market. If there were to be a significant downturn in the state, HTBK's financial profile would be hit, which could in turn jeopardize their ability to continue paying attractive dividends.

In addition, HTBK is exposed to the commercial real estate market due to their loans activity in that segment. As highlighted by the Financial Times recently, defaults are rising in San Francisco's commercial property, as offices, hotels, and retailers are facing a tougher market. Whilst HTBK's management pride themselves in their conservative loan approach, a widespread downturn in this market would impact their prospects and may lead to larger loan loss provisions.

In Conclusion

Heritage Commerce Corp is a profitable and well-capitalized bank that has been swept up in the widespread panic selling that has hit the US regional banks this year. Whilst this market segment should carry a degree of risk premium, HTBK looks well oversold and it is clear that any generic bank concerns regarding unrealized losses on their balance sheet and less than adequate capitalization should not apply to this stock. As a result, I expect HTBK stock to trade back above the $10 mark. As an additional bonus in the meantime, investors will continue to benefit from a long, stable history of solid dividend payments and an attractive Dividend Yield.

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