MRBK - Meridian Corporation: Mortgage Banking Business Will Drag The Bottom Line (Rating Downgrade)

2023-08-16 21:24:32 ET

Summary

• Mortgage banking income will likely remain low because of the rising rate environment. This line item will likely be the biggest contributor to an earnings decline.
• The top line is also likely to decline because of margin pressure.
• The December 2023 target price suggests a small upside from the current market price. Further, MRBK is offering a good dividend yield.
• The risk level appears subdued. The mortgage banking business is the only remarkable risk source because of its high sensitivity to interest rates.

Earnings of Meridian Corporation ( MRBK ) will most probably dip this year because of lower mortgage banking income amid the rising rate environment. Further, pressure on the margin will reduce earnings. Overall, I’m expecting Meridian Corporation to report earnings of $1.49 per share for 2023, down 17% year-over-year. The year-end target price is somewhat close to the current market price. Based on the total expected return, I’m adopting a hold rating on Meridian Corporation.

Expecting Mortgage Income to Remain Low

Mortgage banking income rose during the second quarter of the year compared to the first quarter, as shown below.

I don’t think the second quarter’s performance is an indicator of a change in trend. In my opinion, mortgage banking income is unlikely to turn around before at least the mid of next year. This is because, firstly, as the up-rate cycle is still ongoing, refinancing activity is unlikely to rebound any time soon. Moreover, high borrowing costs and home prices will continue to discourage mortgage purchase activity.

The Mortgage Bankers Association expects mortgage purchase volume to dip by 12% and mortgage refinance volume to plunge by 45% this year.

As a result, I believe income from the mortgage banking segment will remain low until rates start declining by the mid of 2024.

For fee income, I’m expecting the growth rate to be normal. Considering the outlook on mortgage banking income and fee income, I’m expecting total non-interest income to dip by 18% year-over-year in 2023.

Net Interest Income Likely to Dip

Similar to non-interest income, the outlook for net interest income is also lackluster. Firstly, higher interest rates will dampen credit demand. Moreover, the re-pricing of assets and liabilities is set up in a way that the net interest margin is barely affected by interest rate changes. As mentioned in the earnings presentation , the management’s net interest income sensitivity forecast shows a neutral position.

Despite the balance sheet’s neutral position, the margin has actually declined in the first half of the year due to changes in the deposit mix. The proportion of non-interest-bearing deposits in total deposits dipped to 15.1% by the end of June 2023 from 17.6% at the end of December 2022 and 18.6% at the end of June 2022. Going forward, the proportion of non-interest-bearing deposits could fall even further as increases in interest rates could encourage depositors to chase yields and shift their funds towards higher-rate accounts.

One positive factor that can help the net interest income is the unemployment rate. Meridian Corporation operates in Pennsylvania, New Jersey, Delaware, Maryland, and Florida. As shown below, the unemployment rate has been stable at a low rate so far this year. Strong job markets indicate that the business activity is still robust, which bodes well for Meridian Corporation’s loan growth.

Overall, I’m expecting the margin to dip by 10 basis points and the loan portfolio to grow by 4% in the second half of 2023. As a result, I’m expecting Meridian Corporation to report a net interest income of $34 million for the second half of the year, down 2.1% from the first half of the year and down 6.8% from the second half of last year.

The following table shows my balance sheet estimates.

Risks Appear Subdued

Perhaps the biggest source of Meridian Corporation’s risks is the mortgage banking business, which is highly dependent on external factors, namely interest rates and house prices. Other than that, the company’s riskiness is subdued. Unrealized losses on the available-for-sale securities portfolio amounted to $13.3 million at the end of June, which is 9% of the total equity balance. These losses appear low as the equity market value has dropped by 20.68% year-to-date. Moreover, uninsured deposits made up around 23% of total deposits at the end of June 2023, which isn’t too bad. Overall, I think Meridian Corporation’s risk level is low to moderate.

Adopting a Hold Rating

Meridian Corporation is offering a dividend yield of 4.3% at the current quarterly dividend rate of $0.125 per share (assuming no special dividend this year). The earnings and dividend estimates suggest a payout ratio of 34% for 2023, which is below the last two-year average of 39%. Therefore, my earnings outlook does not present a risk to the dividend payout. (Note: Meridian started paying a dividend in 2020, so it’s not apparent yet what level of payout the company is comfortable with.)

I’m using the historical price-to-tangible book (“P/TB”) and price-to-earnings (“P/E”) multiples to value Meridian Corporation. The stock has traded at an average P/TB ratio of 1.066 and an average P/E of 9.038 in the past, as shown below.

Multiplying the average P/TB multiple with the forecast tangible book value per share of $12.0 gives a target price of $12.8 for the end of 2023. This price target implies a 6.5% upside from the August 16 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.

Equally weighting the target prices from the two valuation methods gives a combined target price of $13.1 , which implies a 9.4% upside from the current market price. Adding the forward dividend yield gives a total expected return of 13.6%. As this return isn't high enough for me, I’m adopting a hold rating on Meridian Corporation.

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