2023-03-30 08:30:51 ET
Summary
- OSBC is offering lower rates on deposits than its peers. Therefore, it will have to let its deposit costs rise or risk losing its customers to competitors.
- Economic factors portend lower-than-average loan growth for this year.
- The December 2023 target price suggests a high upside from the current market price. However, OSBC is offering a low dividend yield.
- Due to the high balance of unrealized losses, OSBC is a risky investment.
Earnings of Old Second Bancorp, Inc. ( OSBC ) will likely continue to surge this year on the back of significant margin expansion. Further, subdued loan growth will support earnings growth. Overall, I'm expecting the company to report earnings of $2.00 per share for 2023, up 34% year-over-year. Compared to my last report on the company, I've raised my earnings estimate as I've increased my margin estimate. The year-end target price suggests a high upside from the current price. Therefore, I'm maintaining a buy rating on Old Second Bancorp.
Margin Likely to Continue to Expand, Albeit at a Slower Pace
Old Second Bancorp's net interest margin continued to surge in the last quarter of 2022 as loans repriced higher while deposit costs remained subdued. Despite depositors' preference for higher-yielding accounts amid the high-rate environment, Old Second was able to increase the proportion of non-interest-bearing deposits in total deposits during the last quarter.
SEC Filings
While the shift in deposit mix bodes well for deposit costs in the near term, I don't think these costs can remain so low for long. Old Second Bancorp paid an average rate of just 0.17% during the fourth quarter, as mentioned in the earnings release . This rate is much below the rates some of the company's competitors are paying, as shown below. (Competitors are taken from the latest presentation . They operate in Old Second's markets in Illinois.)
Company Name | Symbol | Total Interest-Bearing Deposits | Savings | Time Deposits |
Old Second | OSBC | 0.17% | 0.03% | 0.50% |
Old National | ONB | 0.49% | 0.10% | 0.89% |
Wells Fargo | WFC | 0.70% | NA | NA |
Huntington | HBAN | 0.88% | NA | NA |
Byline | BY | 1.20% | 0.15% | 1.51% |
Source: SEC Filings |
As Old Second's rates on deposits appear uncompetitive compared to other banks in Illinois, I believe the company will face pressure to raise its deposit costs in order to retain its customers.
The results of the management's rate-sensitivity analysis given in the 10-K filing show that a 200-basis point hike in interest rates could boost the net interest income by 17.3% over twelve months.
2022 10-K Filing
Considering the factors given above, I'm expecting the margin to surge by 25 basis points in 2023. Compared to my last report on the company, I've raised my margin estimate due to the last quarter's above-expected performance and a more hawkish stance on interest rates.
Loan Growth Likely to Remain Below Normal
After strong loan growth in both the second and third quarters of 2023, the portfolio size remained almost unchanged during the fourth quarter of the year. Despite the last quarter's poor showing, the management was confident about loan growth in the near term as pipelines were building up "nicely" at the time of the conference call .
In my opinion, loan growth will likely slow down due to the high interest-rate environment. Further, Illinois, Old Second's main market, has one of the worst unemployment rates in the country, according to official sources . However, the unemployment rate is doing well from a historical perspective.
Considering the factors mentioned above, I'm expecting the loan portfolio to grow by 3.5% in 2023. Further, I'm expecting deposits 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 | 1,878 | 1,911 | 2,001 | 3,377 | 3,820 | 3,955 |
Growth of Net Loans | 17.4% | 1.8% | 4.7% | 68.7% | 13.1% | 3.5% |
Other Earning Assets | 574 | 514 | 824 | 2,425 | 1,619 | 1,668 |
Deposits | 2,117 | 2,127 | 2,537 | 5,466 | 5,111 | 5,318 |
Borrowings and Sub-Debt | 313 | 206 | 161 | 199 | 261 | 269 |
Common equity | 229 | 278 | 307 | 502 | 461 | 543 |
Book Value Per Share ($) | 7.6 | 9.1 | 10.2 | 16.3 | 10.2 | 12.0 |
Tangible BVPS ($) | 6.8 | 8.4 | 9.5 | 13.0 | 8.0 | 9.8 |
Source: SEC Filings, Author's Estimates (In USD million unless otherwise specified) |
Expecting Earnings to Surge by 34%
The continued rise of the net interest margin will drive earnings this year. Further, loan growth will support the bottom line. Consequently, I'm expecting Old Second to report earnings of $2.00 per share for 2023, up 34% year-over-year. The following table shows my income statement estimates.
Income Statement | FY18 | FY19 | FY20 | FY21 | FY22 | FY23E |
Net interest income | 91 | 97 | 92 | 97 | 206 | 272 |
Provision for loan losses | 1 | 2 | 10 | 4 | 7 | 8 |
Non-interest income | 31 | 36 | 37 | 39 | 43 | 38 |
Non-interest expense | 77 | 79 | 81 | 104 | 151 | 180 |
Net income - Common Sh. | 34 | 39 | 28 | 20 | 67 | 91 |
EPS - Diluted ($) | 1.12 | 1.30 | 0.92 | 0.65 | 1.49 | 2.00 |
Source: SEC Filings, Earnings Releases, Author's Estimates (In USD million unless otherwise specified) |
High Earnings at Risk Make OSBC a Risky Investment
Due to a large available-for-sale ("AFS") debt securities portfolio, Old Second Bancorp racked up large unrealized mark-to-market losses last year as interest rates surged. The balance of unrealized losses stood at a hefty $88.9 million at the end of December 2022, as mentioned in the 10-K Filing. To put this number in perspective, $88.9 million is 19% of total equity and 1.3 times the net income reported for 2022. As a result, the net income, and consequently the equity market valuation, will receive a hard hit if Old Second is forced to sell its security portfolio, thereby converting unrealized losses into realized losses.
However, I believe the chances of such an occurrence are slim. Old Second is a regional bank with no material exposure to the Californian markets of the failed banks, SVB Financial ( SIVBQ ), Signature Bank ( SBNY ), and Silvergate Capital ( SI ). Further, Old Second does not deal in venture capital and has no exposure to cryptocurrencies.
Nevertheless, due to the high unrealized losses, and consequently high earnings at risk, I believe Old Second is currently a risky investment.
High Price Upside Calls for a Buy Rating
Old Second is offering a dividend yield of 1.4% at the current quarterly dividend rate of $0.05 per share. The earnings and dividend estimates suggest a payout ratio of 10% for 2023, which is close to the five-year average of 9%. Therefore, I'm not expecting an increase in the dividend level. As it is, Old Second Bancorp does not change its dividend level regularly.
I'm using the historical price-to-tangible book ("P/TB") and price-to-earnings ("P/E") multiples to value Old Second Bancorp. The stock has traded at an average P/TB ratio of 1.32x in the past, as shown below.
FY19 | FY20 | FY21 | FY22 | Average | |
T. Book Value per Share ($) | 8.4 | 9.5 | 13.0 | 8.0 | |
Average Market Price ($) | 12.9 | 9.0 | 12.6 | 14.6 | |
Historical P/TB | 1.53x | 0.94x | 0.97x | 1.83x | 1.32x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the average P/TB multiple with the forecast tangible book value per share of $9.8 gives a target price of $12.9 for the end of 2023. This price target implies a 9.4% downside from the March 29 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.
P/TB Multiple | 1.12x | 1.22x | 1.32x | 1.42x | 1.52x |
TBVPS - Dec 2023 ($) | 9.8 | 9.8 | 9.8 | 9.8 | 9.8 |
Target Price ($) | 10.9 | 11.9 | 12.9 | 13.9 | 14.8 |
Market Price ($) | 14.2 | 14.2 | 14.2 | 14.2 | 14.2 |
Upside/(Downside) | (23.2)% | (16.3)% | (9.4)% | (2.5)% | 4.4% |
Source: Author's Estimates |
The stock has traded at an average P/E ratio of around 9.8x in the past, excluding the outlier in 2021, as shown below.
FY19 | FY20 | FY21 | FY22 | T. Average | |
Earnings per Share ($) | 1.30 | 0.92 | 0.65 | 1.49 | |
Average Market Price ($) | 12.9 | 9.0 | 12.6 | 14.6 | |
Historical P/E | 9.9x | 9.7x | 19.3x | 9.8x | 9.8x |
Source: Company Financials, Yahoo Finance, Author's Estimates |
Multiplying the trimmed average P/E multiple with the forecast earnings per share of $2.00 gives a target price of $19.6 for the end of 2023. This price target implies a 38.1% upside from the March 29 closing price. The following table shows the sensitivity of the target price to the P/E ratio.
P/E Multiple | 7.8x | 8.8x | 9.8x | 10.8x | 11.8x |
EPS 2023 ($) | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 |
Target Price ($) | 15.6 | 17.6 | 19.6 | 21.6 | 23.6 |
Market Price ($) | 14.2 | 14.2 | 14.2 | 14.2 | 14.2 |
Upside/(Downside) | 10.0% | 24.0% | 38.1% | 52.2% | 66.3% |
Source: Author's Estimates |
Equally weighting the target prices from the two valuation methods gives a combined target price of $16.3 , which implies a 14.4% upside from the current market price. Adding the forward dividend yield gives a total expected return of 15.8%. Hence, I'm maintaining a buy rating on Old Second Bancorp. However, investors are warned that the company currently carries a high risk due to its large balance of unrealized losses.
For further details see:
Old Second Bancorp: Margin Growth Is The Biggest Earnings Catalyst