SASR - Sandy Spring Bancorp: Waiting For Spreads To Turn And For The Credit Story To Prove Skeptics Wrong

2023-10-25 23:05:03 ET

Summary

• Sandy Spring Bancorp's third-quarter results showed a noticeable hit to revenue from higher deposit costs, but better than expected operating efficiency.
• The business, and the shares, have been hit hard by an above-average deposit beta and a high level of concern about the outlook for bank CRE portfolios.
• Management guidance suggests a bottom for NIM is in sight, and funding appears more positive, allowing the bank to grow lending some and pull back on promotion deposit offers.
• Sandy Spring shares look undervalued, but it's hard to find reasons for the stock to trade substantially higher until better spreads materialize and credit concerns fade.

Small CRE-heavy banks have definitely gotten hit hard by the market, and Maryland’s Sandy Spring Bancorp (SASR) is no exception, as the shares have fallen more than 40% since my last update – a performance that lags the broader regional bank group, not to mention other similar banks in the area like Carter (CARE), First Community (FCBC), and TowneBank (TOWN).

Back at the time of that last writing (before the March Massacre in banking), I saw elevated risk here to the bank’s spreads (high deposit beta and higher vulnerability to rising deposit rates) and the credit outlook, given a meaningful skew to office and retail properties. I still believe those are salient issues; while the worst of the spread pressure is likely over, the Street is very much in “show me” mode when it comes to the ongoing credit cycle. I can argue for a fair value in the mid-$20’s and potential outperformance on the other side of this rate/credit cycle, but that’s still a ways off and I don’t see a lot of obvious drivers for sentiment in the near term.

Spread Pressures Weigh On Reported Results

Sandy Spring’s third quarter results weren’t that out of line relative to expectations on revenue and operating expense control was better than expected, but there still wasn’t all that much to cheer in the results.

Revenue fell 21% year over year and 5% quarter over quarter, with net interest income (FTE basis) largely matching/driving the revenue numbers (down 21% yoy and almost 5% qoq). Net interest margin declined about a point yoy and 18bp qoq (to 2.55%), and earning assets were barely up versus the prior quarter. Non-interest income rose a little more than 1% on a core basis, with 4% growth in the wealth management business (about 9% of total revenue).

Operating expenses were basically flat with the prior year and down about 7% sequentially on an adjusted basis, driving all of the pre-provision beat versus expectations, and ending with a 62% efficiency ratio – not great, but definitely not the worst I’ve seen this quarter. Pre-provision profits fell 41% yoy and about 1% qoq. Provisioning was also lower than expected, helping the per-share numbers.

Tangible book value per share rose 8% yoy and declined very slightly on a sequential basis.

Accelerating Lending And Better Spreads On The Way?

With a high loan/deposit ratio and rising deposit costs, management has pulled back on lending – looking to basically match payoffs and keep net balances flattish in an effort to boost liquidity. With that, the modest 0.6% sequential decline in loans wasn’t too surprising or concerning. My definition of CRE lending (owner-occupied and investor-owned) was flat sequentially, while construction lending was down 11% and mortgages rose more than 3%.

Loan yield improved some, up 9bp to 5.18%, but this was one of the weaker results I’ve seen and the bank’s loan beta of 21.6% is definitely low as the bank is still looking forward to the benefits/tailwinds from repricings and originations at higher rates. Originations rose 3% sequentially with yields on new loans averaging around 8%, and it sounds as though management is satisfied enough with its liquidity position to start accelerating lending a bit from here.

Management also sounded relatively positive on the spread situation. Sandy Spring has a high deposit beta at 58% (cumulative interest-bearing deposits), but it’s not the worst I’ve seen. Likewise, while interest-bearing deposit costs rose a half-point to 3.14% this quarter, Sandy Spring’s funding costs seem under control.

Non-interest-bearing deposits declined only 2% sequentially and still make up a healthy 27% of total deposits (30% is a good number right now). Management feels comfortable enough with the deposit situation to pull back on some of its promotional efforts – while the bank was offering a 5.5% 8-month CD, the best offer now is a 5.0% 14-month CD.

In discussing guidance, management called for a “high 2.4%’s” net interest margin next quarter, a steady NIM in Q1’24, and then modest sequential improvement (5bp-7bp) in 2024. That’s with another Fed rate hike and no cuts in 2024, and I think that’s important to note as I’ve seen many banks offering NIM guidance on the basis of assuming the Fed is done hiking rates. In other words, I think management is taking a clear-eyed, if not conservative, approach to guidance.

Credit Remains The Unanswerable Question

High rates remain a risk for spreads and there is still ongoing risk of higher unrealized losses in the securities portfolio (sapping tangible equity and liquidity), but I think this is a known risk at this point, and while the tangible equity ratio isn’t as strong as I’d like (8.4%), it’s okay. If rates shoot even higher, investors will likely have plenty to worry about above and beyond Sandy Springs’ share price.

Credit risk is a different story, though. Non-performing loans rose about 5% qoq, and both the non-performing loan and non-performing asset ratios have been steady of late, and the company has logged little in the way of meaningful charge-offs. I’d also note that criticized loans were only 1.5% of CRE loans in the second quarter 10-Q (management didn’t comment on current levels).

Investors are definitely scared about the possibility of outsized loan losses in office loan portfolios, and close to 8% of the bank’s loans are in investor-owned office, and 10% and 14% of the Washington D.C and Baltimore CRE portfolios, respectively, are in office. While I think there are important distinctions here – much of Sandy Springs’ loans are for suburban professional offices, not central business district high-rises, and the D.C. property market has held up well – this is very much a “show me” story and I think Sandy Spring will have to prove these distinctions matter by continuing to post healthy credit numbers.

The Outlook

I don’t think this bank’s office portfolio is going to blow up, but that doesn’t really matter relative to a market that wants little-to-nothing to do with high deposit beta banks with large CRE portfolios. I’m expecting charge-offs for the sector to peak around the end of 2024/first half of 2025 and that’s when we’ll really find out about this bank’s portfolio quality and underwriting.

My revised expectations are in line with the Street for 2023 (a 20%-plus decline in core income) and a bit above for 2024 (a 19% decline), but I’m expecting a significant rebound in 2025 and 2026 as spreads and credit become tailwinds and lending activity picks up again. Long term, I think Sandy Spring can generate 4% to 5% core earnings growth on an annualized basis, and that supports a mid-$20’s fair value today.

I get similar results from my ROTCE-driven P/TBV and P/E approaches; with the latter I’m using a 10x multiple on ’24 earnings (a 30% discount to what I’d normally use).

The Bottom Line

I think management’s guidance is credible, but I do still see some risk to deposit funding and loan demand in the short term. The credit question remains unanswerable – Sandy Spring has navigated past downturns, but every cycle is different and there may be more risk than I expect even though the bank’s office portfolio skews much more toward professional offices in affluent counties. These shares are undervalued and could offer significant upside if and when the positive credit story plays out, but that’s still some ways off and I don’t really see what would move the stock meaningfully higher in the short term.

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