Summary
- The worsening of the deposit mix during the fourth quarter of 2022 will restrict margin expansion this year.
- Economic factors will most probably finally take a toll on loan growth in 2023.
- Inflation will likely worsen the efficiency ratio this year.
- The December 2023 target price suggests a small upside from the current market price. Further, SRCE is offering an unattractive dividend yield.
Earnings of 1st Source Corporation ( SRCE ) will likely remain flattish this year as a surge in operating expenses will counter the effect of loan growth and margin expansion. Overall, I'm expecting 1st Source Corporation to report earnings of $4.94 per share for 2023, up by just 2% year-over-year. Compared to my last report on the company, I haven't changed my earnings estimate much. The December 2023 target price suggests a small upside from the current market price. Therefore, I'm maintaining a hold rating on 1st Source Corporation.
Deposit Mix Shift to Restrict Margin Growth
The rate of margin expansion significantly slowed down during the fourth quarter of 2022. The margin expanded by just nine basis points during the quarter, as opposed to 28 basis points in the third quarter and 15 basis points in the second quarter of the year. One of the reasons for the slowdown was the deterioration of the balance sheet positioning. 1st Source Corporation's deposit mix worsened significantly during the fourth quarter as depositors chased yields and moved their funds into time deposits. As a result, the proportion of both non-interest-bearing and interest-bearing demand and savings accounts dropped during the quarter. The full-quarter impact of the deterioration of the deposit mix will be visible in the first quarter of 2023.
SEC Filings
The outlook is brighter on the asset side. Although fixed-rate loans make up a whopping 65% of total loans, we can expect a significant upward revision in the average loan portfolio yield this year. This is because fixed-rate loans carry short terms. As mentioned in the earnings presentation , the weighted average remaining life of fixed-rate loans was just 2.82 years at the end of December 2022.
I'm expecting the fed funds rate to increase by a further 50 basis points in the first half of 2023 before plateauing. Considering these factors, I'm expecting the margin to expand by 16 basis points in 2023.
Loan Growth Likely to Drop to the Historical Average
In defiance of economic headwinds, especially the high interest-rate environment, 1st Source Corporation's loan growth rate continued to accelerate during the fourth quarter of 2022. The portfolio expanded by 4.4% during the quarter, taking the full-year growth to 12.5%. In my opinion, economic headwinds will finally take a toll on the growth momentum during 2023.
Around 52% of 1st Source Corporation's loans are in the specialty finance segment (trucks, aircrafts, etc.) and the rest are in community banking (mostly businesses). Therefore, the Purchasing Managers' Index ("PMI") is an appropriate indicator of product demand for 1st Source Corporation. As shown below, the PMI index is currently offering a mixed outlook, with the services index in the expansionary territory (above 50) and the manufacturing index in the contractionary territory (below 50).
Overall, I'm expecting the loan growth to drop from last year's extraordinary level to a level closer to the historical average. I'm expecting the loan portfolio to grow by 5% this year, as shown in the table below. The table also shows my estimates for other balance sheet items.
Financial Position | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net Loans | 4,735 | 4,974 | 5,349 | 5,219 | 5,872 | 6,171 |
Growth of Net Loans | 6.8% | 5.1% | 7.5% | (2.4)% | 12.5% | 5.1% |
Other Earning Assets | 1,034 | 1,105 | 1,394 | 2,374 | 1,842 | 1,917 |
Deposits | 5,122 | 5,357 | 5,946 | 6,679 | 6,928 | 7,281 |
Borrowings and Sub-Debt | 329 | 276 | 291 | 330 | 321 | 334 |
Common equity | 762 | 828 | 887 | 916 | 864 | 954 |
Book Value Per Share ($) | 29.4 | 32.4 | 34.7 | 37.0 | 35.0 | 38.6 |
Tangible BVPS ($) | 26.1 | 29.1 | 31.5 | 33.6 | 31.6 | 35.2 |
Source: SEC Filings, Author's Estimates(In USD million unless otherwise specified) |
Inflation to Limit Earnings Growth
Despite a surge in operating expenses during the fourth quarter of 2022, the operating efficiency was still at a remarkable level. The efficiency ratio (calculated as operating expenses divided by total revenues) was at 51.1% during the quarter, up from 49.8% during the third quarter but still well below the 2021 level of 55.3%. In my opinion, the ratio will worsen in 2023 due to the high inflation. Although a clear disinflation trend has been visible for the last six months, inflation is still uncomfortably high when considered in a historical context.
Overall, I'm expecting the efficiency ratio to worsen to 54% in 2023 from 52% in 2022. While the rise in operating expenses will hurt the bottom line, the anticipated loan growth and margin expansion will lift earnings this year. Overall, I'm expecting 1st Source Corporation to report earnings of $4.94 per share for 2023, up by just 2% year-over-year. The following table shows my income statement estimates.
Income Statement | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net interest income | 214 | 224 | 226 | 237 | 263 | 304 |
Provision for loan losses | 19 | 16 | 36 | (4) | 13 | 19 |
Non-interest income | 97 | 101 | 104 | 100 | 91 | 86 |
Non-interest expense | 186 | 189 | 187 | 186 | 185 | 211 |
Net income - Common Sh. | 82 | 92 | 81 | 118 | 120 | 122 |
EPS - Diluted ($) | 3.16 | 3.57 | 3.17 | 4.70 | 4.84 | 4.94 |
Source: SEC Filings, Author's Estimates(In USD million unless otherwise specified) |
In my last report on the company, I estimated earnings of $4.87 per share for 2023. I haven't made any significant changes in any income statement line item. I have only made small tweaks following the fourth quarter's results.
My estimates are based on certain macroeconomic assumptions that may not come to fruition. Therefore, actual earnings can differ materially from my estimates.
Moderate Total Expected Return Calls for a Hold Rating
1st Source Corporation has increased its dividend every year since 2017. Given the earnings outlook, it's likely that the company will maintain the dividend trend this year. Therefore, I'm expecting the company to increase its dividend by $0.02 per share to $0.34 per share in the third quarter of 2023. The earnings and dividend estimates suggest a payout ratio of 27% for 2023, which is close to the five-year average of 30%. Based on my dividend estimate, 1st Source is offering a forward dividend yield of 2.7%.
I'm using the historical price-to-tangible book ("P/TB") and price-to-earnings ("P/E") multiples to value 1st Source Corporation. The stock has traded at an average P/TB ratio of 1.43 in the past, as shown below.
FY19 | FY20 | FY21 | FY22 | Average | |
T. Book Value per Share ($) | 29.1 | 31.5 | 33.6 | 31.6 | |
Average Market Price ($) | 46.7 | 36.6 | 46.7 | 49.1 | |
Historical P/TB | 1.61x | 1.16x | 1.39x | 1.55x | 1.43x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/TB multiple with the forecast tangible book value per share of $35.2 gives a target price of $50.3 for the end of 2023. This price target implies a 1.8% upside from the February 24 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.
P/TB Multiple | 1.23x | 1.33x | 1.43x | 1.53x | 1.63x |
TBVPS - Dec 2023 ($) | 35.2 | 35.2 | 35.2 | 35.2 | 35.2 |
Target Price ($) | 43.3 | 46.8 | 50.3 | 53.8 | 57.4 |
Market Price ($) | 49.4 | 49.4 | 49.4 | 49.4 | 49.4 |
Upside/(Downside) | (12.5)% | (5.3)% | 1.8% | 8.9% | 16.0% |
Source: Author's Estimates |
The stock has traded at an average P/E ratio of around 11.2x in the past, as shown below.
FY19 | FY20 | FY21 | FY22 | Average | |
Earnings per Share ($) | 3.6 | 3.2 | 4.7 | 4.8 | |
Average Market Price ($) | 46.7 | 36.6 | 46.7 | 49.1 | |
Historical P/E | 13.1x | 11.5x | 9.9x | 10.1x | 11.2x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/E multiple with the forecast earnings per share of $4.94 gives a target price of $55.3 for the end of 2023. This price target implies an 11.8% upside from the February 24 closing price. The following table shows the sensitivity of the target price to the P/E ratio.
P/E Multiple | 9.2x | 10.2x | 11.2x | 12.2x | 13.2x |
EPS 2023 ($) | 4.94 | 4.94 | 4.94 | 4.94 | 4.94 |
Target Price ($) | 45.4 | 50.3 | 55.3 | 60.2 | 65.2 |
Market Price ($) | 49.4 | 49.4 | 49.4 | 49.4 | 49.4 |
Upside/(Downside) | (8.2)% | 1.8% | 11.8% | 21.9% | 31.9% |
Source: Author's Estimates |
Equally weighting the target prices from the two valuation methods gives a combined target price of $52.8 which implies a 6.8% upside from the current market price. Adding the forward dividend yield gives a total expected return of 9.5%. This expected return isn't high enough for me; therefore, I'm maintaining a hold rating on 1st Source Corporation.
For further details see:
1st Source Corporation: Flattish Earnings Outlook, Lackluster Valuation