One-Time Items Mask Stronger Core At Berkshire Hills Bancorp

Summary

• 2018 could be a breakout year for reported earnings as core growth battles its way through significant one-time items.
• High-end EPS estimates require asset growth rates that I don't think will be hit, but that's not to say that only modest growth wouldn't support an improved valuation.
• Cost of funds are rising and could be a headwind.

After looking into some smaller banks in Massachusetts, I thought I’d check-in on a larger peer that was growing through expansion. For this, we turn to Berkshire Hills Bancorp (NYSE:BHLB), an $11.5 billion asset bank that passed the $10 billion (higher regulatory threshold) mark after its purchase of Commerce Bancshares closed in October (2017).

Sourced from 10-K

As you can see from above, YOY earnings fell 26% due to several one-time items (net security gains, merger and acquisition charges, and one-time tax adjustments), which compares to adjusted earnings growth of 22.3%. This is an acquisitive bank and I like that the new purchase helped add some much-needed deposits (loan to deposit ratio from 108% in 2013 to 94% in 2017) that can be used to either grow loans or lower the balance of more expensive other borrowings (total borrowings fell 13.6% YOY).

However, it’s important to note that the current valuation doesn’t afford many more accretive deals (based on P/TBV of 1.89X). At this point in the cycle, most financials in this area trade at or around the same level. This is a casual observation but based on my take of earning projections it’s one that could end-up being a major headwind.

Targets

As a little warning, the financials are extremely hard to get a read on because of several one-time items. Because of this, I chose to walk through the performance targets that management outlined on the earnings call and rely on management’s core earnings calculations to try to find the most important items and/or constraints. This involves some basic math. For those uninterested in reading this section, my takeaway is that to hit the high-end of the targets (core EPS growth of 20%) the team needs to cut significant operating costs and/or grow YOY assets by more than 20% (4-year CAGR is 19.51%).

On the 4^th quarter call, management said they expect 1^st quarter core EPS to grow 10-12% to $0.63-$0.65 and that the diluted share count will average 46.2 million shares. For the year, with growth and a lower tax rate, the bank is targeting EPS growth of 17-20%, with core ROA above 1% and the efficiency ratio below 60%.

With reported earnings in mind, I had to do a second take when I read over this part of the transcript (caused by initial disbelief), but after running through the numbers they do appear to be within reach (my math follows):

17-20% growth on core earnings of $2.30 gets us to $2.69-2.76 in 2018. Based off of this, and with diluted shares at 47.58 million (3% + 46.2 million – my estimate), net earnings will fall between $127.9-131.3 million. To earn this with an ROA of 1%, assets need to grow between 20-27%. With management’s (from call) core tax rate of 23% (actually said between 22-24%), pre-tax earnings would be between $166-170.5 million.

Assuming no acquisitions and loan growth of 12%, a decent provision estimate is ~$22 million (based on average loan balance of $8.8 billion, net charge-offs of 0.17% and $7 million more for coverage). Add $22 million to $166-170.5 million pre-tax, and pre-provision pre-tax income is $188-192.5 million. Divide $188-192.5 million by 40% (yields revenue based on 60% efficiency ratio), and pre-provision net interest revenues rise to $470-481 million, while non-interest expenses come to $282-288 million.

To get a feel for how reasonable these assumptions were, I compared them to annualized 4^th quarter results:

• Pre-Provision Net Interest Revenues: $462 million vs. $470-481 million estimate
• Provision Charge: $24.8 million vs. $22 million estimate
• Adjusted Non-interest Expense: $300 million vs. $282-288 million estimate
• Net Income: $104 million (core net income stated by management in earnings release) vs. $127.9-131.3 million estimate.

We’ll have to see how this plays out, but on the whole not too unreasonable. Annualized 4^th quarter pre-provision net interest revenues are already within the projected range, although after stripping 4^th quarter discount loan accretion of $5.5 million, the annualized amount falls to $440 million (compares to estimate of 470-481 million). My only problem with this walk-through is that it requires either organic asset growth of 20-27%, which is above the 4-year CAGR (19.51%) that includes a couple acquisitions, or a ~10% cut in core non-interest expenses.

This is a hard ask, but even falling short with earnings growth of 12-15% would be a breakthrough for core results that in the past have been hidden by a long line of nonrecurring merger-related items – the highest reported EPS in the last 5-years was $1.88 in 2016, which compares to 2017 adjusted (core) earnings of $2.30.

Other Headwinds

Portfolio

Like most financials, BHLB is targeting business assets (Commercial & Industrial Loans and Commercial Real Estate) to increase yields and better position the portfolio for higher rates.

This has significantly shortened repricing schedules, but there are still a lot of residential assets that have rates locked in for 5-15 years and +15 years.

Management indicated that the pipeline for commercial loans was healthy and growing, but there is a lot of competition for these lines. The strategy appears to be gathering deposits in smaller areas and growing loans in Boston, where headquarters were recently relocated. On the call, management indicated that at year-end deposits in Boston were $0.5 billion compared to loans of $3 billion. These steps are moves in the right direction, but trying to lower the allocation of residential loans, the portfolio’s biggest asset, is a headwind to the larger balance sheet the bank needs to hit earnings targets.

Deposits

Another headwind is the bank’s other borrowings and heavy reliance on certificates of deposits. In 2017, these two line items accounted for 51.9% of total interest-bearing liabilities. CD’s with a 1.17% yield are 2X more expensive than the yield paid on any other type of deposit (next closest was 0.58% on money market accounts – balance of money market accounts is $1.9 billion compared to CD’s of $2.58 billion). The yield on other borrowings is 1.88%, up from 1.19% in 2016 (following tables from 10-K).

The bank's interest rate projections show a slight increase in interest income this year for rate changes between +100-200 basis points (up 1.41% and 2.39% respectively), but this funding mix is a lot more volatile and a lot less attractive than the ones we found at Enterprise Bancorp (EBTC) and Cambridge Bancorp (OTC:CATC).

BHLB’s cost of funds (average liability yield) of 0.77% compares to 0.31% for EBTC and 0.2% for CATC. BHLB’s loan to deposit ratio of 94% compares to 92.9% for EBTC and 76% for CATC. Based on these two items alone, incremental growth for BHLB is more expensive, and funding costs are more likely to increase at a relatively faster pace in a rising rate environment.

Bottom Line

There are some hurdles to clear before hitting the high-end of management’s growth targets, but even low-end earnings projections are attractive. One-time items from taxes and a string of acquisitions have shares trading closer to the long-term average price to tangible book value multiple - but note that 1% ROA is significantly higher than reported results in any of the past 10-years.

In addition, improved earnings expectations have the forward P/E down from ~16.8 to 13.74.

15X reported earnings is near the bottom of where shares have traded (shown below). Low-end earnings projections of $2.69 in 2018 are within reach, and with a 15X multiple they would help shares appreciate to $40.35 (7.3% + 2.35% dividend = total return of 9.65%). I don’t find this type of high cost growth strategy attractive, but the bank is capturing market share through expansion and if margins improve this could end up yielding an above average return for investors.

This isn’t one to buy if you are concerned with market volatility, but it could be a profitable medium-term play (1-2 years), and it’s worth pointing out that insiders have started to buy.

This is not the conclusion I was expecting to come to, but that’s why it’s worth digging into the details even when an investment opportunity doesn’t have the profile you typically look for (in my case: low-cost structure, without the need for above-average asset growth, with above-average earnings growth).

From OpenInsider.Com

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.