SSB - SouthState: Reducing The Earnings Estimate And Downgrading To A Hold Rating

2023-05-28 06:42:52 ET

Summary

• I’ve revised upwards my estimate for provisions expenses following the first quarter’s poor performance.
• Loan growth will likely outpace deposit growth, which will hurt the margin.
• The December 2023 target price suggests a moderate upside from the current market price. SouthState is offering a decent dividend yield.
• SSB has quite a large balance of uninsured deposits, which increases the stock’s risk level.

Earnings of SouthState Corporation (SSB) will likely surge this year on the back of loan growth. I'm expecting the company to report earnings of $7.46 per share for 2023, up 13% year-over-year. Compared to my last report on the company, I've reduced my earnings estimate as I've raised my provisions estimate. After switching my valuation method, the year-end target price suggests a moderate upside from the current market price. Therefore, I'm downgrading SouthState Corporation stock to a Hold rating.

Provisioning to Remain Elevated

SouthState surprised me by posting a very large provision expense for loan losses during the first quarter of 2023. The company reported a net provision expense of $33 million for the quarter, which is an annualized 0.44% of total loans. In comparison, the net provision expense has averaged only 0.16% of loans in the last five years.

The loan portfolio's asset quality also significantly worsened during the quarter. Non-performing assets jumped to 0.42% of loans and OREO by the end of March 2023 from 0.36% at the end of December 2022, as mentioned in the presentation . The non-performing assets to loans ratio has continuously risen every quarter since the second quarter of last year. As a result, I think provisioning should remain elevated for the remainder of the year.

Fortunately, the loan portfolio is well diversified across loan categories, which reduces some of the riskiness. Further, the loan portfolio is well-diversified geographically as it has a presence in Florida, Alabama, Georgia, North Carolina, South Carolina, and Virginia.

Additionally, around 76% of the loan portfolio is backed by real-estate loans. The only real estate that's currently risky is office property. There is a chance that some office property loans will go bad and the market value of those properties will plunge due to the persistent work-from-home and hybrid work culture. Although commercial real estate loans are a big part of the loan portfolio, office properties make up just 4% of SouthState's total loans. As the company's exposure is limited, the credit risk from the office sub-segment is not worrisome.

Overall, I'm expecting the company to report a provision expense of $75 million for 2023, or 0.24% of total loans. In comparison, the net provision expense averaged 0.16% of loans in the last five years. Compared to my last report on the company, I've increased my estimates for the remaining quarters as well as the full year because of the first quarter's negative surprise and poor performance.

Earnings to Suffer from Gap Between Loan and Deposit Growth

After declining by 6.5% in the second half of 2022, the deposit book stabilized during the first quarter of 2023. However, that stability was attributable to costly brokered Certificates of Deposits ("CD"). Excluding brokered CDs, deposits declined by $1.2 billion during the quarter, or 3.3%.

The continued decline in cheap, core deposits is worrisome because it will lead to higher interest expenses. To resolve its funding issues, SouthState Corporation will likely have to resort to costly CDs or borrowings. Funding issues will also hurt the company's willingness to lend. Loan growth had already slowed down to 1.7% in the first quarter of 2023 from 4.6% in the last quarter of 2022. The management will have to walk a fine line between growing its balance sheet and making sure the growth doesn't hurt the margin.

Apart from funding constraints, the high-interest-rate environment will also restrict loan growth. Consumer mortgage loans and home equity lines of credit, which make up 22% of total loans, are especially vulnerable to interest rate changes.

On the plus side, regional economic factors bode well for loan growth. SouthState Corporation serves several states in the South-Eastern and Eastern United States, namely Florida, Alabama, Georgia, the Carolinas, and Virginia. The unemployment rates of all of these states are currently quite low compared to their respective histories.

Considering these factors, I'm expecting the loan portfolio to grow by 4.0% and the deposit book to grow by 0.9% in 2023. The following table shows my balance sheet estimates.

Unrealized Losses, Uninsured Deposits Add to the Risks

Apart from the credit risks discussed above, SouthState's earnings are also at risk from the unrealized mark-to-market losses amassed on the Available-for-Sale securities portfolio during the ongoing up-rate cycle. As of the end of March 2023, these unrealized losses amounted to $817 million, which is around 16% of total equity. I'm expecting most of these losses to reverse when interest rates start declining next year. However, there is a chance that the management will elect to sell these securities at a loss and use the proceeds to fund higher-yielding loans.

Further, uninsured and uncollateralized deposits present some risks in case there is a deposit run on the bank. According to details given in the 10-Q filing, uninsured and uncollateralized deposits totaled approximately $10.8 billion at the end of March 2023, representing a sizable 30% of total deposits.

Overall, I believe SouthState Corporation's risk level is moderate.

Downgrading to a Hold Rating

SouthState is offering a dividend yield of 3.1% at the current quarterly dividend rate of $0.50 per share. The earnings and dividend estimates suggest a payout ratio of 27% for 2023, which is close to the five-year (ex-2020) average of 30%. Therefore, the dividend appears secure.

Previously, I was using the historical price-to-earnings (P/E) and price-to-tangible book (P/TB) multiples to value SouthState Corporation. These multiples were quite high; therefore, they led to a high target price. For this report, I've decided to take peer P/E and P/TB multiples because I think the stock is unlikely to trade near its high historical multiples any time soon. Peers are trading at an average P/TB ratio of 1.53 and an average P/E ratio of 9.3, as shown below.

Multiplying the average P/E multiple with the forecast earnings per share of $7.46 gives a target price of $69.5 for the end of 2023. This price target implies a 7.0% upside from the May 26 closing price. The following table shows the sensitivity of the target price to the P/E ratio.

Equally weighting the target prices from the two valuation methods gives a combined target price of $70.1 , which implies a 7.8% upside from the current market price. Adding the forward dividend yield gives a total expected return of 10.9%. This expected return isn't high enough considering the risks; therefore, I'm downgrading SouthState Corporation to a hold rating from my previous rating of buy.

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