Hingham Institution For Savings: Growth Rates Starting To Pressure Shares

Summary

• HIFS turned in another great report for the year with ROAs of 1.22%.
• However, margins are down and starting to pressure the bank's more expensive shares.
• Loans continue to outpace deposits, requiring higher-yielding short-term funds that will reprice faster than assets as rates start to increase.
• I'm cautious because the bank is at an inflection point and on the other side is below average earnings growth.
• 2017 earnings increased by 8.45%, which compares to the 4-year average CAGR of 17.1%.

Hingham Institution for Savings (NASDAQ:HIFS) reported net income of $11.81 per diluted share for 2017, an increase of 8.45% over 2016 results. The bank's return on average assets (ROA) during 2017 was 1.22%, a 1 basis point improvement over the 1.21% posted in the comparable period of 2016.

In my last article on the name, I modeled out a simple scenario that brought assets to $3.5 billion in ~5 years. To get there with ~3.5 years remaining, assets need to add ~13% a year, which is slightly below last year and the 4-year trailing CAGR. I said simple scenario, so my projections only required the asset growth rate, a 1.2% return on assets (bank currently producing 1.22%) and a 12.5 earnings multiple (which compares to the 5-year average of ~13.93) to net shareholders a 16% annualized return.

I was trying to be conservative, by assuming a below average P/E multiple and no rerating, but while fundamentals are on track the market clearly had other plans. Today's shares at $204 are up 36.4% since July of 2016, but down significantly from the 52-week high of $241.59. I got out after the announcement of tax changes sent shares up to ~$230 in December. This is a high-quality company that could be considered a forever hold, but the market was ready for my sale and I was starting to worry about margin pressure.

As you can see in the table above, weak deposit growth has required more expensive financing (Federal Home Loan Bank Advances) to keep up with the portfolio. This is not a new development, but in a rising rate environment, it's especially risky considering portfolio duration.

From 10-K

It helps that 67% of the portfolio has adjustable rates (shown above), but in 2018 $1.299 billion in liabilities reprice compared to assets of $777 million. That's a major short-term headwind, and one that is already harming NIMs as the cost of borrowing rises and higher-yielding legacy loans mature. Remember, YOY growth on larger portfolios mean that a large number of loans were written at historically low rates.

From 10-K

Needless to say, I expect some volatility and I also don't think the market price reflects any change in asset quality. This is a top-tier bank, and adjustable rates allow for more room to (aggressively) grow the balance sheet than would be feasible under a fixed rate regime, but credit pressure is sure to rise when everything around the bank's customer base starts to cost more.

Market

Before we close, I thought it would be a good idea to check in on regional trends.

The light grey lines in the graph below are the growth rates for other MSA's in the state of Massachusetts. As you can see, the Boston housing price index has appreciated at a rate that is only slightly greater than the US average, and well above other parts of the state.

Supporting this move are lower home vacancy rates.

I couldn't find anything screaming for lower prices in the near future. But, it's noteworthy that asset growth rates in the area fell significantly in the last quarter.

HIFS has been growing assets and loans faster than the average financial. This has worked so far but like the company's peers, margins are under pressure. The peer average of ~3.3% compares to NIMs of 3.05% for HIFS.

Without adding volume as it has in the past, growth in net income could stall. This isn't a move we've seen HIFS make, yet, but note that falling regional net interest income correlates very closely with the asset growth rates we observed earlier.

Also, note that loan loss reserves are near record lows. Since 2013, HIFS's allowance to loan ratio has fallen from 0.78% to 0.68%.

Long-Term Value

My last call to buy was based on the fact that I thought the bank's growth trajectory wasn't completely priced into the market. This discount is mostly gone and I don't like the bank's leverage nor below average NIMs, but HIFS is a long-term holding that makes it work by sourcing margin not accessible to peers.

As you can see below, HIFS has a model that has allowed for explosive growth in assets per employee.

HIFS may be targeting lower-yielding assets and using more expensive leverage for financing, but this strategy makes it so that the company pays less than half of what it costs other high performing banks in the area for each dollar of revenue (the efficiency ratio is operating costs divided by the sum of net interest income and noninterest income).

I still think we see $3.5 billion in assets in the next few years, which is the driver management is targeting - more interest-bearing assets added to an inexpensive cost structure - but in the interim, I expect some volatility as the market fluctuates in and around fair value.

With this in mind, I cashed in my chips when the market took shares to where I thought they would trade in two years, but the risk is missing out on the long-term upside that the bank is looking to capture by taking its show on the road.

In the annual report, the letter from the President stated that:

We also began building our business in greater Washington D.C., providing commercial real estate financing and private banking services to the same kind of real estate investors, families, and nonprofits that we serve in Boston. We believe that the banking market in Washington, D.C. has experienced a level of consolidation and disruption that has left these customers underserved. We offer a commitment to independence, a balance sheet that can support meaningful lending relationships up to $35 million, and speed and surety of execution. If you own or manage commercial real estate in Boston or Washington, call us.

Part warning (for competitors) and a major next step for this 184-year-old bank - as it most likely moves the target for the future balance sheet to well past $3.5 billion.

Bottom Line

This is a great bank that's worth buying at the right price but today's shares offer returns that are much lower than where we found them in 2016 (when the stock was at trading near the 52-week high).

There are mounting headwinds, and I don't like the company's assets in a rising rate environment. I'm not as wise as management is, but this review mirrors the caution President Gaughen, Jr. shared in the 4th quarter report when he stated that:

Performance in any one period, especially periods when tailwinds may be with us, should be viewed cautiously. Such periods are historically fraught with peril in our industry. The real test of performance in banking is a company's record of compounding shareholder capital over time and through all stages of the credit cycle.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.