2023-04-07 07:20:29 ET
Summary
- A surge in non-interest expenses will undermine the effect of moderate loan growth.
- Unrealized mark-to-market losses on the available-for-sale securities portfolio are very high, at around 44% of total equity. Therefore, FISI’s risk level is high.
- The December 2023 target price suggests a very high upside from the current market price.
- FISI is offering a dividend yield of over 6%. Further, the dividend payout appears secure.
Earnings of Financial Institutions, Inc. (FISI) will likely be flattish this year. Moderate loan growth will drive earnings while a hike in non-interest expenses will drag earnings. Overall, I'm expecting the company to report earnings of $3.51 per share for 2023, down 1% year-over-year. Compared to my last report on the company, I've reduced my earnings estimate as I've raised my non-interest expense estimate. The risk level of Financial Institutions Inc. is moderately high due to sizable unrealized losses. Further, the year-end target price suggests a very high upside from the current market price and the dividend yield is over 6%. Considering the total expected return and the risk level, I'm maintaining a buy rating on Financial Institutions Inc.
Loan Outlook is Mixed After a Phenomenal Year
The loan portfolio surged by 4.8% during the fourth quarter of 2022, which beat my expectations. This growth was organic and broad-based. I'm expecting growth to slow down significantly for 2023 due to higher interest rates which will dampen credit demand. The residential mortgage segment will get hurt the most as its demand relies heavily on borrowing costs. This segment made up a sizable 16% of total loans at the end of December 2022, therefore, a slowdown in this segment will have a significant impact on total loan growth.
A positive development for the residential mortgage segment is that home prices have recently softened. Financial Institutions, Inc. mostly operates in New York State with a limited presence in Maryland. As shown below, the house price indices for both states have flattened.
Further, the two states' unemployment rates are near record lows (excluding New York City), which indicates healthy business activity and bodes well for commercial loan growth.
The management mentioned in the latest conference call that it expects mid to high-single-digit loan growth in 2023. Considering the conflicting factors given above and management's guidance, I'm expecting the loan portfolio to grow by 4% in 2023. The following table shows my balance sheet estimates.
Financial Position | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net Loans | 3,053 | 3,191 | 3,543 | 3,640 | 4,005 | 4,168 |
Growth of Net Loans | 13.0% | 4.5% | 11.0% | 2.7% | 10.0% | 4.1% |
Other Earning Assets | 895 | 781 | 904 | 1,390 | 1,144 | 1,167 |
Deposits | 3,367 | 3,556 | 4,278 | 4,827 | 4,929 | 5,130 |
Borrowings and Sub-Debt | 509 | 315 | 79 | 104 | 279 | 291 |
Common equity | 379 | 422 | 451 | 488 | 388 | 404 |
Book Value Per Share ($) | 23.8 | 26.3 | 28.1 | 30.6 | 25.1 | 26.1 |
Tangible BVPS ($) | 19.0 | 21.6 | 23.5 | 25.9 | 20.4 | 21.4 |
Source: SEC Filings, Author's Estimates (In USD million unless otherwise specified) |
Revising Upwards the Operating Expenses Estimate
The Federal Reserve has increased its PCE inflation projection to 3.3% for 2023 from its previous projection of 3.1%. Despite the upward revision, the projected inflation number is still much below the last reading of 5.0% for February 2023 ; therefore, the Fed's revision is not a cause for concern. Nevertheless, it's reason enough to update my estimates.
Considering the updated inflation projection, I'm expecting non-interest expenses to grow by 8.9% in 2023 to $141 million. In comparison, I previously estimated non-interest expenses of $139 million for this year.
Reducing the Earnings Estimate
As discussed above, loan growth will likely be the key earnings driver for 2023. On the other hand, a surge in non-interest expenses will drag the bottom line.
Meanwhile, the margin will barely change as it is hardly rate sensitive. The management mentioned in the conference call that it expects the margin to be in the range of 3.30% - 3.35% in 2023, up from 3.23% in the fourth quarter of 2022. In my opinion, the management is being too optimistic given the margin only rose by eight basis points by the end of 2022 from the end of 2021. Further, the management's simulation model shows that a 200-basis points hike in rates could increase the net interest income by just 0.35% (see below), as mentioned in the 10-K Filing . As a result, I'm expecting the net interest margin to grow by just two basis points in 2023.
2022 10-K Filing
Moreover, I'm expecting non-interest income to remain flattish from the fourth quarter's level. Further, I'm expecting the provision expense as a percentage of total loans to be close to the historical average.
Considering these factors, I'm expecting earnings to dip by 1% to $3.51 per share in 2023. The following table shows my income statement estimates.
Income Statement | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net interest income | 123 | 130 | 139 | 155 | 167 | 179 |
Provision for loan losses | 9 | 8 | 27 | (8) | 13 | 13 |
Non-interest income | 36 | 40 | 43 | 47 | 46 | 45 |
Non-interest expense | 101 | 103 | 109 | 113 | 129 | 141 |
Net income - Common Sh. | 38 | 47 | 37 | 76 | 55 | 54 |
EPS - Diluted ($) | 2.39 | 2.96 | 2.30 | 4.78 | 3.56 | 3.51 |
Source: SEC Filings, Earnings Releases, Author's Estimates (In USD million unless otherwise specified) |
In my last report on Financial Institutions, Inc, I estimated earnings of $3.74 per share for 2023. I've reduced my earnings estimate mostly because I've raised my non-interest expense estimate.
Risk Level Makes FISI Unsuitable for Certain Investors
I upgraded FISI to a buy rating in December 2022. The stock has performed poorly since then and returned negative 21.86% mostly because of the recent bank failures and the resultant rise in the banking sector's risk level. The stock price has corrected by 23.5% since March 8, 2023, when Silvergate Capital ( SI ) collapsed ( news source ) and triggered panic in the banking sector.
I understand the reason behind the initial panic in the stock as FISI had unrealized mark-to-market losses of $172.7 million on its available-for-sale ("AFS") securities portfolio at the end of 2022. This number is huge as it is around 44% of the total equity balance at the end of 2022 and more than three times the net income reported for last year. In the unlikely case that FISI is forced to sell its AFS portfolio and incur these losses, then the market value could've possibly tumbled by 44% from the March 8th price, as opposed to the actual correction of 23.5%.
However, while I understand the initial panic, I don't think the stock price should remain depressed much longer. This is because, firstly, there have been no new bank failures over the last two weeks, and most of the dust seems to have settled. Secondly, FISI does not have exposure to cryptocurrencies or digital tokens. The company also does not focus on start-ups. Further, uninsured deposits made up 26% of total deposits at the end of 2022, which isn't too high.
I believe one cause for vigilance is the capital level, which is above regulatory requirements by a small margin. The company reported a total capital ratio of 12.13% at the end of 2023, as opposed to the minimum regulatory requirement of 10.50% (including the capital conservation buffer).
Overall, I believe FISI's risk level is moderately high. As a result, this stock appears unsuitable for low-risk-tolerant investors.
Maintaining a Buy Rating
Financial Institutions Inc. is offering a hefty dividend yield of 6.5% at the current quarterly dividend rate of $0.30 per share. The earnings and dividend estimates suggest a payout ratio of 34% for 2023, which is close to the five-year average of 36%. Therefore, the dividend appears secure.
I'm using the historical price-to-tangible book ("P/TB") and price-to-earnings ("P/E") multiples to value Financial Institutions, Inc. The stock has traded at an average P/TB ratio of 1.18x in the past, as shown below.
FY19 | FY20 | FY21 | FY22 | Average | |
T. Book Value per Share ($) | 21.6 | 23.5 | 25.9 | 20.4 | |
Average Market Price ($) | 29.2 | 20.0 | 30.1 | 27.6 | |
Historical P/TB | 1.35x | 0.85x | 1.16x | 1.36x | 1.18x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/TB multiple with the forecast tangible book value per share of $21.4 gives a target price of $25.2 for the end of 2023. This price target implies a 36.7% upside from the April 6 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.
P/TB Multiple | 0.98x | 1.08x | 1.18x | 1.28x | 1.38x |
TBVPS - Dec 2023 ($) | 21.4 | 21.4 | 21.4 | 21.4 | 21.4 |
Target Price ($) | 20.9 | 23.1 | 25.2 | 27.3 | 29.5 |
Market Price ($) | 18.5 | 18.5 | 18.5 | 18.5 | 18.5 |
Upside/(Downside) | 13.5% | 25.1% | 36.7% | 48.2% | 59.8% |
Source: Author's Estimates |
The stock has traded at an average P/E ratio of around 8.2x in the past, as shown below.
FY19 | FY20 | FY21 | FY22 | Average | |
Earnings per Share ($) | 2.96 | 2.30 | 4.78 | 3.56 | |
Average Market Price ($) | 29.2 | 20.0 | 30.1 | 27.6 | |
Historical P/E | 9.9x | 8.7x | 6.3x | 7.7x | 8.2x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/E multiple with the forecast earnings per share of $3.51 gives a target price of $28.7 for the end of 2023. This price target implies a 55.3% upside from the April 6 closing price. The following table shows the sensitivity of the target price to the P/E ratio.
P/E Multiple | 6.2x | 7.2x | 8.2x | 9.2x | 10.2x |
EPS 2023 ($) | 3.51 | 3.51 | 3.51 | 3.51 | 3.51 |
Target Price ($) | 21.6 | 25.1 | 28.7 | 32.2 | 35.7 |
Market Price ($) | 18.5 | 18.5 | 18.5 | 18.5 | 18.5 |
Upside/(Downside) | 17.2% | 36.3% | 55.3% | 74.4% | 93.4% |
Source: Author's Estimates |
Equally weighting the target prices from the two valuation methods gives a combined target price of $26.9 , which implies a 46.0% upside from the current market price. Adding the forward dividend yield gives a total expected return of 52.5%.
The substantial total expected return calls for a Strong Buy rating. However, due to the risk level discussed above, I believe it's better to maintain a Buy rating on Financial Institutions, Inc. I'd like to reiterate here that FISI is unsuitable for low-risk-tolerant investors.
For further details see:
Financial Institutions, Inc.: Dividend Yield, Price Upside, And Risk Are All High