Evans Bancorp: Credit Costs To Undermine Acquisition Benefits

Summary

• EVBN has material exposure to COVID-19 sensitive industries, which will likely drive provision expense in the year ahead.
• The net interest margin will likely contract in the second quarter following the federal funds rate cuts of March.
• The acquisition of FSB Bancorp will increase earning assets, which will, in turn, support earnings for the year.
• Risks and uncertainties will most probably negate the attractive valuation in the near-term.

Earnings of Evans Bancorp (NYSE:EVBN) plunged to $0.04 per share in the first quarter from $0.75 per share in the last quarter of 2019. Earnings will likely improve from the first quarter but remain below 2019's earnings in the remainder of this year. The provision expense will likely remain above normal in the year ahead on the back of the company's exposure to COVID-19 sensitive industries. Further, net interest margin contraction following the interest rate cuts in March will pressurize earnings in the remaining three quarters. Moreover, EVBN will likely book high one-time merger-related expenses in the second quarter. On the other hand, loan growth through the acquisition of FSB Bancorp and the Paycheck Protection Program will likely support the bottom line. Overall, I'm expecting earnings per share to decline by 55% year-over-year in 2020 to $1.53. After adjusting for the one-time merger costs, I'm expecting EVBN to book earnings of $2.43 per share. The probability of an earnings miss is unusually high this year because the impact of the COVID-19 pandemic on future provision expense is uncertain, and consequently, difficult to predict. The December 2020 target price suggests a high upside from the current market price, but due to the uncertainties, I'm adopting a neutral rating on EVBN.

Exposure to High-Impact Industries to Drive Credit Costs

EVBN's provision expense surged to $3 million in the first quarter of 2020, from $0.5 million in the first quarter of 2019. I'm expecting provision expense to decline from the first quarter in the remainder of the year, but remain above-normal. EVBN has material exposure to industries that have been hit hard by the COVID-19 pandemic, which will likely drive credit costs in the remainder of the year. Details given in the June 2020 investor presentation suggest that risky industries make up around 13.6% of total loans. Hotels make up 5.6% of total loans, retail/wholesale trade makes up 3.2%, restaurants make up 3.2%, and the medical/assisted living segment makes up 1.6% of total loans. As a result, I'm expecting EVBN to post provision expense of $4.8 million in 2020, or 31 basis points of total loans, up from 1 basis point of total loans in 2019.

FSB Acquisition to Boost the Loan Portfolio

EVBN's loan balance increased by 1.4% by the end of the first quarter from the end of 2019. I'm expecting loans to receive a boost from the merger and acquisition activity in the second quarter. EVBN announced last month the completion of the acquisition of FSB Bancorp, the holding company of Fairport Savings Bank. The acquisition will likely add around $300 million to EVBN's loan portfolio in the second quarter. Further, based on the details given in the presentation, I'm expecting the acquisition to increase deposits by an estimated $300 million. Moreover, I'm expecting the FSB acquisition to increase EVBN's assets, excluding loans, by around $90 million.

EVBN's participation in the Paycheck Protection Program, PPP, will also boost the loan portfolio in the second quarter. As mentioned in the June 2020 presentation, EVBN processed $140 million worth of loans in the first round and $52 million worth of loans in the second round of PPP. As a majority of the PPP loans will likely get forgiven within a few months, I'm expecting EVBN to book most of the fees from PPP in the third quarter of 2020. Further, due to the loan forgiveness, the year-end loan balance will not fully reflect the effect of PPP during the year. Considering these factors, I'm expecting EVBN's loan book to grow by 38% quarter-over-quarter in the second quarter. Further, I'm expecting the company to end the year with loans of $1.5 billion, up 27% from the end of 2019. The following table shows my estimates for loans and other balance sheet items.

A decline in the net interest margin, NIM, will partially offset the loan growth benefit for net interest income. The 150 basis points cut in the federal funds rate will pressurize yield in the second quarter, thereby leading to a reduction in NIM. According to the results of a simulation disclosed in the 10-Q filing, as of December 31, 2019, a 100 basis points reduction in interest rates could reduce net interest income by $2.5 million over 12 months. This simulation gives an idea about NIM's rate-sensitivity. Overall, I'm expecting NIM to decline by 14bps in the second quarter and by 29bps in the full year. The following table shows my estimates for yield, cost, and NIM.

Expecting Earnings of $1.53 per Share

The surge in provision expense and NIM contraction will likely pressurize earnings this year. Additionally, as mentioned in the presentation, EVBN will book an estimated $5.3 million in one-time restructuring charges for the acquisition of FSB, which will contribute to an earnings decline. On the other hand, loan growth due to the FSB acquisition and participation in PPP will likely support the bottom line. Overall, I'm expecting earnings per share to decrease by 55% year-over-year to $1.53 in 2020. Adjusting for the one-time merger-related charge, I'm expecting EVBN to post earnings per share of $2.43 per share, down 29% from the earnings for 2019. The following table shows my estimates for income statement items.

EVBN's material exposure to COVID-19 sensitive industries, and the uncertainties surrounding the severity and duration of the pandemic, make it hard to predict future provision expense. As a result, the probability of a negative earnings surprise is unusually high this year, which increases EVBN's riskiness.

Risks Tarnish High Upside Potential

I'm using EVBN's historical average price-to-tangible-book ratio, P/TB, to value the stock. As shown in the following table, EVBN has traded at an average P/TB multiple of 1.41 in the past.

Multiplying this average P/TB ratio with the forecast tangible book value per share of $27 gives a target price of $38.1 for December 2020. This price target implies an upside of 69% from EVBN's June 12 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.

Apart from the opportunity for capital appreciation, EVBN is also offering a decent dividend yield of 5%. The dividend yield estimate is based on the assumption that the company will maintain its semi-annual dividend at $0.58 per share. I'm not expecting a cut in dividend because the earnings and dividend estimates suggest a payout ratio of 71%, which is manageable.

As discussed above, EVBN has a high level of risk due to the uncertainties surrounding the pandemic and the company's exposure to COVID-19 sensitive industries. In my opinion, the risks will overshadow the attractive valuation in the near-term, thereby making the stock price range-bound. As a result, I'm adopting a neutral rating on EVBN.

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.

Disclaimer: This article is not financial advice. Investors are expected to consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.