2023-07-19 08:30:50 ET
Summary
- Mercantile Bank Corporation's Q2 2023 earnings reveal a significant increase in net income and revenue, exceeding expectations; however, the bank faces risks such as increased interest expenses and competition for deposits.
- Despite these challenges, the bank's strategic positioning and undervalued P/E ratio may present a buying opportunity, with the company's stock significantly surging by +12.16%.
- The bank's future prospects appear promising due to its strategic positioning with floating-rate commercial loans and an anticipated federal funds rate hike; however, investors should be cautious.
Thesis
Mercantile Bank Corporation's ( MBWM ) Q2 2023 earnings showcase a remarkable improvement in net income, with diluted earnings per share ((EPS)) of $1.27 beating expectations by $0.17. The bank's revenue of $55.20 million, a year-over-year increase of 31.21%, also exceeds estimates by $3.35 million. However, in my analysis, I also point out that the bank faces risks such as amplified interest expenses, rising overhead costs, unrealized losses on investments, interest rate dependence, and intensified competition for deposits. Yet, despite these challenges, the bank's strategic positioning and undervalued P/E ratio may present a buying opportunity.
Company Profile
Incorporated back in 1997 and with its headquarters nestled in Grand Rapids, Michigan, Mercantile Bank operates as the umbrella entity for Mercantile Bank of Michigan, delivering a plethora of commercial and retail banking services to a broad spectrum of clients, primarily focusing on small to medium-sized businesses, as well as individual customers across the United States.
On a more ancillary note, Mercantile provides courier services and safe deposit facilities, adding another feather to its diverse service cap. Further, it extends its portfolio to insurance products, encompassing a range of coverage from auto and homeowners to more specific policies like boat owners, recreational vehicle, dwelling fire, small business, and life insurance products.
Mercantile Bank's Q2 2023 Earnings Highlights
Let's start things off by noting the marked surge in net income, almost doubling to $20.4 million - or $1.27 per diluted share - in Q2 2023 from $11.7 million, or $0.74 per diluted share, year-over-year. The fiscal story unfurls further with the revelation that the net income for H1 2023 stood tall at $41.3 million, or $2.58 per diluted share, outpacing the $23.2 million or $1.47 per diluted share in H1 2022. This is underscored by an elevated net interest income and fortification of loan quality metrics, which deftly held provision expenses at bay.
The year's first half also witnessed the bank's interest income on an upward spiral, a result of the burgeoning interest rate landscape and a sturdy push in commercial and residential mortgage loans. Here's a striking feature: a considerably beefed-up net interest margin in H1 2023 against the same period in the previous year, an outcome of the rise in the federal funds rate since March 2022. The rising interest rates serve to bolster the two-thirds of the bank's commercial loans that operate on a floating rate.
On the flip side, interest expenses also felt the pinch of the high-interest environment and a heated race for deposits. Nonetheless, the bank's net interest income emerged victorious, displaying considerable expansion.
Despite the bank wrestling with escalated overheads during 2023, largely due to amplified compensation and higher interest rate swap collateral holding costs, an augmented net interest margin signaled an escalated yield on earning assets. This reflects the boon of the ascending interest rate situation.
In the realm of loans, the bank's strategic positioning with two-thirds of commercial loans having a floating rate leaves it poised to make hay in a climate of rising interest rates. Coupled with around 83% of the bank's loans primed for repricing in the next five years, the prospects for further interest income in a high rate environment appear promising.
The bank also retains its hearty, well-capitalized regulatory capital stance. While rising interest rates led to escalated net unrealized losses in the investment portfolio, this paradoxically translated into a beneficial impact on the net interest margin, ultimately fueling the growth of net interest income and net income.
Peering into the future, Mercantile anticipates a federal funds rate hike of 0.25% in July 2023 and projects total loan growth within 5-6% for both commercial and residential mortgage loan portfolios. Despite anticipated high payoffs and paydowns, a marginal dip in net interest margin is forecasted.
Expectations
Mercantile Bank is covered by five Wall Street analysts who have an average " Buy " rating on the company that culminates to reflect a +13.53% upside price target.
Performance
I believe it warrants highlighting that, after digesting the information from Mercantile's late-day conference call , the company's stock significantly surged, culminating the day on a strikingly high note of +12.16%, as the market's closing bell tolled.
Seeking Alpha
Next, stepping back and extending our optics over the medium-term (see data below) Mercantile's dividend payout ratio history has been the black sheep of consistency, hovering between 31.98% and 66.40% over the past eight years. This erratic nature could be a red flag for the more risk-averse among us.
Despite this, the bank has been showing an average dividend growth rate of 11.89% over 8 years. Not too shabby, however, let's not forget the compound growth rate which sits at a rather melancholic -8.12%.
When it comes to the total return scenario, comparing Mercantile with the S&P 500 Index, the annualized ROR without dividends for Mercantile was 5.71% vs. S&P's 9.74%. Add in the dividends and we've got a compound growth of 8.87% for Mercantile against S&P's 10.92%.
Valuation
Firstly, the P/E ratio stands at 7.58x (see chart below), which to my mind is significantly undervalued, given the fact that the company's Normal P/E Ratio is 13.28x. This discrepancy generally signifies a golden opportunity and if we compare Mercantile's P/E to its industry's standard, it's clear that the market is underpricing the bank. Also, the adjusted earnings growth rate of 12.15% is a strong sign that Mercantile's operations are on a steady upward trajectory.
Risks & Headwinds
Interest Expense Surge: Diving deeper into Mercantile Bank's financials , it's clear that a significant factor influencing their bottom line is the amplified interest expense on deposits and advances from the Federal Home Bank of Indianapolis. Amid an environment where interest rates are marching higher, the bank's interest-related expenses have predictably swelled. The monetary landscape we're navigating is double-edged; while higher interest rates can mean beefed-up interest income, it can also translate to amplified costs tied to interest, potentially straining the bank's profit margins. If we continue to see the pendulum swing towards a higher interest rate environment, the bank might feel a pinch on their profitability, especially if it fails to offset these costs with commensurate rises in interest income or operational efficiencies.
Heightened Overhead Costs: Another critical aspect deserving our attention is the upward trajectory of the bank's overhead costs. During the first half of 2023, with the second quarter serving as a significant contributor, the bank's overheads were buoyed by a concoction of increased compensation costs, greater reserve allocations for unfunded loan commitments, and escalated interest rate swap collateral holding costs. Now, any surge in operational costs warrants vigilance since it can gnaw away at profitability. If the bank doesn't take effective measures to control these rising costs or improve operational efficiency, it could lead to profit constriction, impacting overall financial performance.
Unrealized Losses Looming: Another red flag hoisted in the bank's financials is the steep ascent in net unrealized losses on its investment portfolio. As of June 30, 2023, these losses have swelled to a notable $78 million, with a significant credit given to the higher interest rate environment. Essentially, these unrealized losses can be seen as a reflection of the potential damage the bank might suffer if they were to liquidate these investments today. While it's not an immediate threat, persistent expansion of these losses could have consequences down the line, especially if market conditions deteriorate or the bank needs to liquidate some of its investments.
Tougher Competition for Deposits: Lastly, it's worth noting that Mercantile Bank's management acknowledged grappling with intensified competition for deposits. This scenario can ratchet up the cost of gathering deposits, as banks often need to offer more enticing interest rates to attract and retain depositors in a competitive landscape. This development can squeeze their net interest margin, the difference between interest earned from loans and the interest paid out to depositors. If competition continues to heat up, the bank will need to strategize to secure its deposit base without overpaying, or risk a contraction in their net interest margin, potentially dampening profitability.
Final Takeaway
Taking into account the impressive surge in Mercantile Bank's net income, their strategic positioning with floating-rate commercial loans, and a current undervalued P/E ratio, I would lean towards a "buy" recommendation. However, investors should tread with caution due to rising interest expenses, heightened overhead costs, and the bank's dependence on high interest rates for their income.
For further details see:
Mercantile Bank's Strong Q2 Earnings Offer A Buying Opportunity