- The increase in earning assets following the acquisition of Park Bank will likely drive earnings in the remainder of the year.
- Provision expense will likely normalize in the second quarter. FMBI has limited exposure to COVID-19-sensitive industries.
- The target price suggests a high upside from the current market price, which justifies a bullish rating.
Earnings of First Midwest Bancorp (NASDAQ:FMBI) plunged to $0.18 per share in the first quarter, down 62% from the last quarter of 2019. Earnings for the remainder of the year will likely improve from the first quarter, but decline on a year-over-year basis. The increase in earning assets following the acquisition of Park Bank in the first quarter will likely drive up earnings in the year ahead. Moreover, the provision expense will likely normalize in the second quarter, which will help earnings recover from the first quarter’s low. On the other hand, the net interest margin will likely decline in the second quarter following March’s interest rate cuts, which will pressurize earnings. For the full year, I’m expecting earnings per share to decline by 36% to $1.17. The December 2020 target price suggests a high upside from the current market price; therefore, I’m adopting a bullish rating on FMBI.
Loan Growth from Park Bank Acquisition to Counter Margin Decline
FMBI completed its acquisition of Park Bank in March, which increased FMBI’s loans by around $720 million, as mentioned in the press release. The increase in earning assets will likely help earnings recover in the remainder of the year. Further, FMBI’s participation in the Paycheck Protection Program (PPP) will boost loans in the second quarter. As mentioned in the first quarter’s investor presentation, FMBI has funded $1.2 billion of PPP loans, which will increase total loans in the second quarter. I’m expecting a majority of these loans to get forgiven by the third quarter; hence, the year-end loan balance will not reflect some of the loan growth during the year. Overall, I’m expecting net loans to stand at $13.9 billion at the end of 2020, up 8.8% from the end of 2019. The following table shows my estimates for loans and other balance sheet items.
A decline in net interest margin, NIM, following the interest rate cuts in March, will partially offset the benefit of loan growth. FMBI’s NIM is quite rate-sensitive because a majority (around 54%) of total loans were floating-rate loans as of March 31, 2020, as mentioned in the first quarter’s 10-Q filing. At the same time, around 79% of total loans were demand deposits or interest-bearing core deposits, which either did not pay interest or whose rates changed at a slower pace than short-term interest rates. We can gauge the rate-sensitivity by the results of a simulation conducted by the management. As mentioned in the 10-Q filing, the results show that a 100bps decline in interest rates can reduce net interest income by 8.5% over twelve months. The following table from the 10-Q filing shows the results of the simulation.
The management expects NIM to continue to decline, and net interest income, excluding accretion, to be modestly lower in 2020 compared to 2019, as mentioned in the presentation. Purchase accounting accretion will likely decline naturally in the year ahead. Considering the factors mentioned above and management’s guidance, I’m expecting NIM to decline by 27bps in the second quarter and by 64bps in the full year. Further, I’m expecting net interest income to decline by 4% year over year in 2020. The following table shows my estimates for yield, cost, and NIM.
Credit Costs to Normalize Due to Limited Exposure to COVID-19-Sensitive Industries
FMBI’s provision expense surged to $40 million in the first quarter from $10 million in the last quarter of 2019. I’m expecting FMBI’s provision expense to return to normal in the second quarter as FMBI has limited exposure to industries hit hard by COVID-19. As mentioned in the investor presentation, high-risk industries made up just 5% of total loans as of March 31, 2020. Further, unsecured consumer loans made up just 2% of total loans. Consequently, I’m expecting FMBI to book average provisions expense of $12 million in each of the three remaining quarters of the year, which is a normal level. This estimate will lead to a full-year provision expense of $76 million in 2020, up from $44 million in 2019. The following table from the presentation gives the details of the risky loan segments.
Non-Interest Expense to Remain Stable in the Year Ahead
FMBI booked one-time acquisition costs of $5.5 million in the first quarter following the acquisition of Park Bank. Acquisition costs will likely remain high in the second quarter because the management plans to convert Park Bank's systems in June, as mentioned in the first quarter’s conference call. The tapering-off of these costs in the latter half of the year will contribute to a sequential decline in non-interest expenses. The management mentioned in the conference call that it expects merger costs of roughly $5 million in the second quarter, which should drop down to at most $1 million in the third quarter and then nothing afterward. According to management’s guidance given in the presentation, the expense run rate for the first quarter will continue for the remaining three quarters. Based on management’s guidance, I’m expecting FMBI’s non-interest expense to increase by 5.9% year over year in 2020.
Expecting Earnings of $1.17 per Share
I’m expecting earnings to recover from the first quarter’s low in the remainder of the year on the back of provision expense normalization. Further, the addition to loans from the Park Bank acquisition will likely help earnings improve in the remainder of the year from the first quarter’s decline. On the other hand, the decline in NIM will pressurize earnings. For the full year, I’m expecting earnings to decline by 36% year over year to $1.17 per share. The following table shows my income statement estimates.
The severity and persistence of the COVID-19 pandemic are uncertain; therefore, there are chances of a negative earnings surprise in the year ahead. In my opinion, fears of a second dip in economic activity or a second lockdown will remain until a vaccine for COVID-19 is developed. Additionally, the fees that will be booked under PPP this year is uncertain as it will depend upon the number of loans forgiven this year, which is unknown. However, I believe that FMBI is less risky than peer banks because of its limited exposure to risky industries. As discussed above, only 5% of FMBI’s total loans are to COVID-19-sensitive industries, and 2% are unsecured consumer loans.
Year-end Target Price Suggests 35% Upside
I'm using the historical price-to-tangible-book multiple, P/TB, to value FMBI. The stock traded at an average P/TB ratio of 1.52 in 2019. Multiplying the average P/TB ratio with the forecast book value per share of $13.7 gives a target price of $20.8 for December 2020. This price target implies a 35% upside from FMBI's June 9 closing price. The following table shows the sensitivity of the target price to the P/TB multiple.
Apart from the opportunity for capital appreciation, FMBI is offering a modest dividend yield of 3.6%. The dividend yield estimate is based on the assumption that the company will maintain its dividend at the current level of $0.14 per share in the remainder of 2020. There is very little threat of a dividend cut because the earnings and dividend estimates suggest a payout ratio of 48%, which is sustainable. Based on the high price upside, modest dividend yield, and relatively low risk, I’m adopting a bullish rating on FMBI.
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