SFST - Southern First Bancshares: It Will Get Worse Before It Gets Better

2023-04-03 10:30:00 ET

Summary

• Southern First Bancshares has a portfolio focused on loans. The total amount of securities is less than 3% of the assets and does not pose a major risk.
• SFST will have to (continue to) focus on its loan book. As of the end of 2022, less than 0.10% of the total assets were non-performing, that is good.
• The majority of the loan book has fixed interest rates and this will weigh on the net interest income and earnings.
• I expect a 30-40% EPS decrease this year before seeing a gradual improvement in 2024 as loans mature and cash is redeployed in higher yielding assets.

Introduction

About a year ago, I argued Southern First Bancshares ( SFST ), the holding company for the Southern First Bank in South Carolina, could potentially be more interesting at a slightly lower share price. Now, 12 months later, the share price is trading approximately 36% lower which would qualify as more than just a ‘slightly’ lower share price. Of course the entire banking sector is currently in turmoil but as Southern First recently filed its updated annual report over FY 2022, perhaps this is a good

A strong result in 2022 but increasing interest rates will temporarily weigh on the results

In this article, I will first have a look at the bank’s performance in 2022 before moving over to a balance sheet discussion. A lot of banks have been hit hard by the impact of their securities portfolios: liquid assets but due to the rapidly increasing interest rates on the market there are some reported and unreported losses in those portfolios.

But first things first. In 2022, Southern First saw its interest income increase to $118M while its interest expenses almost quadrupled to $20M as the net interest margin fell below 3% in the final quarter of the year. This resulted in a net interest income of $97.6M which is more than 10% higher than the 2021 result and more than 20% higher than the 2020 net interest income.

The bank also reported a $9.6M non-interest income and a $63M in non-interest expenses for a net non-interest expense of approximately $53M. That’s more than the $39M in 2021 due to the much lower mortgage banking income and higher operating expenses in general.

The pre-tax and pre-provision income came in at $44.3M and as the bank recorded a $6.2M provision for loan losses, the reported pre-tax income was $38.1M, resulting in a net income of $29.1M or $3.66 per share. The bank does not pay a dividend so the earnings are integrally added to the balance sheet. This helped to mitigate the impact of the unrealized losses in the security portfolio.

With virtually no securities AFS on the balance sheet, investors need to focus on the loan book

The unrealized losses on the investment portfolio were low because SFST’s securities portfolio is very small. As you can see below, the bank had only $93.3M in securities AFS and no securities held to maturity. This means that the future fallout from the additional pressure from interest rate increases should be pretty benign.

This means we need to have a closer look at the actual loan portfolio on Southern First’s balance sheet. The bank has in excess of $3.2B in loans, which is a massive increase compared to the loan portfolio at the end of 2020 and 2021. As you can see below, about 63% of the loan book consists of commercial loans with 70% of the commercial loans invested in commercial real estate.

The remainder of the loan book is classified as consumer loans with the vast majority (about 90% of the consumer loans) consisting of residential real estate and home equity loans. Of the $3.2B+ loan book, about 5% is maturing this year. AS you can see below, about $175M matures this year, followed by on average $216M per year in the next four years. That’s encouraging as borrowers paying off their loans should result in a decent inflow of cash. With about a third of the loan book maturing within five years, I have the impression Southern First’s duration risk is well-managed.

It's also important to know the vast majority of the loan book consists of fixed rate loans and only a small portion (low double digit percentage) of the loans has a variable or adjustable interest rate.

That’s important because it means Southern First will likely see a negative short term impact of interest rate increases as it will have to wait for existing loans to roll off before being able to redeploy the capital in higher-yielding loans as right now, only a small portion of the loan book is exposed to increasing interest rates.

The bank knows this, and it has provided an updated estimate of how the net interest income will be impacted based on a shift in the interest rates. As you can see below, a 200 basis point interest rate increase across the board will reduce the net interest income by 11%. An increase of 300 basis points will have a negative impact of 16.6% as Southern First will need time to see the impact of higher market rates on its interest income.

Using the 300 basis point scenario, the net interest income would decrease by approximately $16M which would have a negative impact of approximately $1.55 on the EPS. In this case, the EPS would drop to just $2.10 per share before starting to recover. That recovery could happen relatively fast: if $170M of the loans due this year can be recycled into new loans at a 250 basis point higher interest rate, the net interest income would increase again by $4.3M resulting in a $0.40 EPS increase. And as more loans will mature in the coming years, the EPS will accelerate again. An additional benefit here is that Southern will continue to retain its earnings which could help to expand the loan book or perhaps start buying more securities to ensure liquidity remains strong. Retaining $17M in earnings and deploying that at a 4% interest income would also add between 5 and 10 cents per share to the earnings profile.

This also means that by the end of 2024 the bank will likely be back on course to generate north of $3/share in EPS as by that point about $400M in loans will have been repaid and those proceeds will likely be used to issue new loans at a substantially higher interest rate. Additionally, the bank will likely retain about $30-40M in earnings in this two year period.

Let’s also not forget to have a look at the bank’s access to liquidity. Let’s pull up the asset side of the balance sheet again.

On a total of $3.7B, the bank has $171M in cash and $93M in securities available for sale. That’s not a whole lot considering the total amount of deposits at the end of 2022 exceeded $3.1B. This means that if depositors would take 10% of their cash out on any given day, the bank would face a liquidity issue.

Investment thesis

Of course, a lot may have happened between the end of last year and the end of Q1 so I will be looking forward to the Q1 results of the bank. I’m not worried about its solvency as the bank had just $2.6M in non-performing assets which is less than 0.10% of the total asset base . And that will be very helpful if the bank would have to sell a portion of its loan book (or use it as collateral) to ensure it has access to liquidity. The bank appears to be strong for now, and it will be up to its management team to navigate through these choppy waters and to protect its liquidity buffers.

I currently have no position in Southern First Bancshares.

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