Summary
- The margin will continue to expand due to a highly rate-sensitive loan portfolio. However, the high deposit beta will restrict the margin’s growth.
- The average loan balance for this year will be much higher than in 2022 because of last year's acquisition.
- Organic growth for this year will likely be lower than in previous years.
- The December 2023 target price suggests a moderate upside from the current market price. Further, FRME is offering a decent dividend yield.
Earnings of First Merchants Corporation (FRME) will surge this year partly on the back of the acquisition of Level One Bancorp last year and the resultant jump in the average loan balance. Further, the margin will continue to expand in 2023 due to a highly rate-sensitive loan portfolio. Overall, I'm expecting First Merchants to report earnings of $4.65 per share for 2023, up 22% year-over-year. The year-end target price suggests a moderate upside from the current market price. Based on the total expected return, I'm adopting a buy rating for First Merchants Corporation.
Further Margin Expansion is Likely Thanks to a Highly Rate-Sensitive Loan Book
The rate of margin expansion dipped in the last quarter of 2022 but remained at a satisfactory level. The margin grew by 17 basis points during the quarter, as opposed to 27 basis points in the third quarter and 25 basis points in the second quarter of the year.
The outlook remains satisfactory largely because of the highly rate-sensitive loan portfolio. The average loan yield is quite rate-sensitive as variable-rate loans made up 66% of total loans at the end of December 2022, as mentioned in the earnings presentation .
4Q 2022 Earnings Presentation
Unfortunately, the deposit book is also very rate sensitive. Savings and interest-bearing demand accounts altogether made up a hefty 69% of total deposits at the end of December 2022. These deposits reprice regularly; therefore, they will reflect the changes in market interest rates with only a small lag. Further, the management mentioned in the conference call that competition for deposits continues to increase, which could boost the deposit beta (rate sensitivity).
The results of management's rate-sensitivity analysis given in the third quarter's 10-Q filing showed that a 200-basis points hike in interest rates could boost the net interest income by 2.4% over twelve months. The annual 10-K filing has not been released as yet.
3Q 2022 10-Q Filing
I'm expecting a further 50 basis points rate hike till the mid of 2023; therefore, the margin should continue to expand this year. Further, the repricing of fixed-rate loans will lift the margin. Considering all these factors, I'm expecting the margin to grow by 10 basis points in 2023.
Last Year's Acquisition to Continue to Bear Fruit This Year
First Merchants Corporation's organic loan growth continued strongly during the last quarter of 2022. The portfolio grew by 3.1% during the quarter, taking the full-year growth to 30.2%, which includes the acquisition of Level One Bancorp in the second quarter of the year.
I'm expecting loan growth for 2023 to be lower than in previous years. My thesis is based on the high interest-rate environment which should dampen credit demand across the board, but especially for residential loans which made up 17.5% of the total loan portfolio at the end of December 2022.
First Merchants Corporation is present in Indiana, Michigan, Ohio, and Illinois. All of these Midwestern states currently have slower-paced economic activity than the national average, as shown below.
Considering these factors, I'm expecting the loan portfolio to grow by 6% by the end of December 2023 from the end of 2022. However, the average loan balance will be much higher this year compared to last year because of the acquisition of Level One Bancorp in the second quarter. I'm expecting the average balance to be 15% higher this year relative to 2022.
Meanwhile, I'm expecting other balance sheet items to grow somewhat in line with loans. The following table shows my balance sheet estimates.
Financial Position | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net Loans | 7,144 | 8,379 | 9,113 | 9,046 | 11,781 | 12,504 |
Growth of Net Loans | 7.0% | 17.3% | 8.8% | (0.7)% | 30.2% | 6.1% |
Other Earning Assets | 1,674 | 2,723 | 3,543 | 5,010 | 4,399 | 4,532 |
Deposits | 7,755 | 9,840 | 11,362 | 12,733 | 14,383 | 15,265 |
Borrowings and Sub-Debt | 671 | 733 | 685 | 634 | 1,314 | 1,354 |
Common equity | 1,408 | 1,786 | 1,851 | 1,888 | 2,010 | 2,201 |
Book Value Per Share ($) | 28.5 | 34.6 | 34.1 | 35.0 | 34.7 | 38.0 |
Tangible BVPS ($) | 19.0 | 23.4 | 23.6 | 24.4 | 21.8 | 25.1 |
Source: SEC Filings, Author's Estimates(In USD million unless otherwise specified) |
Expecting Earnings to Surge by 22% in 2023
As I'm expecting loan growth to be lower than in previous years, the provisioning for expected loan losses will likely also be lower. Further, the provisioning already incorporates the scenario of a mild recession, as mentioned in the conference call. Therefore, I'm not expecting the realization of a recession to have a significant impact on provisioning. Overall, I'm expecting the net provision expense to make up around 0.08% of total loans in 2023, which isn't much below the average of 0.18% for the last five years.
Apart from the below-average provisioning, the bottom line will also receive support from the slight margin expansion and loan growth discussed above. Overall, I'm expecting First Merchants Corporation to report earnings of $4.65 per share for 2023, up 22% year-over-year. The following table shows my income statement estimates.
Income Statement | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net interest income | 339 | 357 | 382 | 411 | 520 | 631 |
Provision for loan losses | 7 | 3 | 59 | - | 17 | 10 |
Non-interest income | 76 | 87 | 110 | 109 | 108 | 98 |
Non-interest expense | 220 | 247 | 263 | 279 | 356 | 401 |
Net income - Common Sh. | 159 | 164 | 149 | 206 | 221 | 269 |
EPS - Diluted ($) | 3.22 | 3.19 | 2.74 | 3.81 | 3.81 | 4.65 |
Source: SEC Filings, Earnings Releases, Author's Estimates(In USD million unless otherwise specified) |
My estimates are based on certain macroeconomic assumptions that may not come to fruition. Therefore, actual earnings can differ materially from my estimates.
Moderately-High Total Expected Return Warrants a Buy Rating
First Merchants Corporation has increased its dividend in the second quarter of almost every year in the past decade. Given the earnings outlook, I'm expecting the company to raise its dividend by $0.02 per share in the second quarter of 2023, leading to a full-year dividend payout of $1.34 per share. The earnings and dividend estimates suggest a payout ratio of 29% for 2023, which is close to the five-year average of 32%. Based on my dividend estimate, First Merchants is offering a forward dividend yield of 3.1%.
I'm using the historical price-to-tangible book ("P/TB") and price-to-earnings ("P/E") multiples to value First Merchants Corporation. The stock has traded at an average P/TB ratio of 1.63 in the past, as shown below.
FY19 | FY20 | FY21 | FY22 | Average | |
T. Book Value per Share ($) | 23.4 | 23.6 | 24.4 | 21.8 | |
Average Market Price ($) | 38.0 | 29.7 | 42.8 | 41.2 | |
Historical P/TB | 1.62x | 1.26x | 1.76x | 1.89x | 1.63x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/TB multiple with the forecast tangible book value per share of $25.10 gives a target price of $41.00 for the end of 2023. This price target implies a 5.0% downside from the February 2 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.
P/TB Multiple | 1.43x | 1.53x | 1.63x | 1.73x | 1.83x |
TBVPS - Dec 2023 ($) | 25.1 | 25.1 | 25.1 | 25.1 | 25.1 |
Target Price ($) | 35.9 | 38.4 | 41.0 | 43.5 | 46.0 |
Market Price ($) | 43.1 | 43.1 | 43.1 | 43.1 | 43.1 |
Upside/(Downside) | (16.6)% | (10.8)% | (5.0)% | 0.8% | 6.6% |
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 ($) | 3.19 | 2.74 | 3.81 | 3.81 | |
Average Market Price ($) | 38.0 | 29.7 | 42.8 | 41.2 | |
Historical P/E | 11.9x | 10.8x | 11.2x | 10.8x | 11.2x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/E multiple with the forecast earnings per share of $4.65 gives a target price of $52.10 for the end of 2023. This price target implies a 20.8% upside from the February 2 closing price. The following table shows the sensitivity of the target price to the P/E ratio.
P/E Multiple | 9.2x | 10.2x | 11.2x | 12.2x | 13.2x |
EPS 2023 ($) | 4.65 | 4.65 | 4.65 | 4.65 | 4.65 |
Target Price ($) | 42.8 | 47.4 | 52.1 | 56.7 | 61.4 |
Market Price ($) | 43.1 | 43.1 | 43.1 | 43.1 | 43.1 |
Upside/(Downside) | (0.7)% | 10.0% | 20.8% | 31.6% | 42.4% |
Source: Author's Estimates |
Equally weighting the target prices from the two valuation methods gives a combined target price of $46.50 , which implies a 7.9% upside from the current market price. Adding the forward dividend yield gives a total expected return of 11.0%. Hence, I'm adopting a buy rating on First Merchants Corporation.
For further details see:
First Merchants Corporation: Margin Expansion, Last Year's Acquisition To Boost Earnings