Heritage Commerce: A Commercial Real Estate Lender With Limited Growth Opportunities

Summary

• Continued margin compression and a shrinking loan portfolio is likely to limit profitability upside.
• An above peer valuation leaves minimal upside appreciation potential.
• While credit does look healthy today, HTBK had a rather poor performance in the last recession.

Photo by Sundry Photography/iStock via Getty Images

Investment Thesis

In terms of relative asset size, San Jose, California-based Heritage Commerce Corp. (NASDAQ:HTBK) is in a sweet spot. Heritage is $4.6 billion asset bank, which is large enough to garner cost efficiencies and promote internal growth strategies. Also, it's big enough to move the needle for another regional bank looking to acquire assets through a merger. Finally, if it were to attempt to be the buyer in a deal, nearly any bank it decides to partner with would help drive improved earnings and asset growth in a meaningful way.

While this northern California bank does have as sizable advantage over the more traditional community bank, in my mind, its large dependence on commercial real estate is likely to play an unforeseen headwind to the company. While it was a good source of growth over the past decade, I believe the 67% of loans related to California real estate is likely to be a valuation headwind (when compared to current levels).

In terms of a credit perspective, I don’t have a problem with commercial real estate in San Jose, especially given its close proximity to Silicon Valley. That said, I have a feeling that asset values at the aforementioned real estate locations are likely to face headwinds in the coming years. In a vacuum, it's not a bad thing, but in terms of growth its hard to see any new developers looking to build in an area (and need new loans) that is under pricing pressure.

In my mind, HTBK should garner a slight premium to peers due to its “sweet spot” asset size which I laid out earlier. Conversely to that, I think the limited forward path for above average growth coupled with a strong possibility for sluggish earnings is likely to keep shares where they are today.

In terms of valuation, I believe price to tangible book value is appropriate given the relative pricing and the potential for being acquired. As it currently stands, HTBK is trading near 1.9x on price to tangible book value, which compares to 1.65x at regional peers. In terms of relative valuation juxtaposed against takeout potential, I think this ~0.25x premium is warranted and HTBK is likely to trade in line with peer banks going forward - which directly drives my neutral stance on the shares.

Data by YCharts

Revenue Analysis and Outlook

While the loan portfolio is not likely to experience a draconian shrinking effect, PPP related loans do account for 11% of total loans and it will be difficult a headwind to overcome over the next few quarters as they are forgiven. With that said, I think future earnings are likely to come down just a little, however, this is more of a net interest margin shrinking effect than anything balance sheet related.

In terms of the balance sheet, while nearly every bank makes most of its revenue in the spread difference of loans and deposits, few understand that both new loans and the repricing of legacy loans play a major effect on future earnings. In fact, average earnings asset yields, which are largely driven by loan re-pricing tend to be about 80% of the driver to future earnings, with the remining 20% coming from the funding side (i.e. deposits and debt sources).

Source: SEC Filings and Author's Estimates

For Heritage specifically, once you back out PPP related income in its soon to be inflated net interest income, I think the margin will drift a little lower than the most recent levels. As on can see from the chart above, the net interest margin is likely to increase slightly as spread revenue is going to include accelerated PPP related income sparked by SBA granted forgiveness. Once that rather one-time effect works its way off both the income statement and balance sheet, the future margin is likely to be a little lower, but unlikely to drift below 3.00%.

Outside of spread revenue, fee income is likely to hold steady. While most of the banking industry saw inflated income statements and profitability metrics, HTBK did not since it does not do much mortgage related business. Going forward, as peer banks start to see sluggish fee income (on a year over year perspective) from a slowing mortgage market, HTBK is likely to see continued fee growth from its solid core businesses.

Credit and Concluding Thoughts

When it comes to commercial real estate credit analysis, there are a couple major drivers. First, rent and cash flows from owner occupied leases is the easiest to measure since the tenant owns the building. Second, the value of property itself, which is derived from a large swath of things like rent prices, length of tenant contracts, occupancy, quality, location, etc.

While credit itself can be a major headwind to earnings (via the loan loss provision), for HTBK’s commercial real estate lending, the value of the building would need to fall or the tenant would need to default on its agreement. While it's hard to imagine a sizable amount of credit downgrades in a positive economic growth world, it can happen, and I am a little sceptical of HTBK’s credit relative to peers – especially given its history (see below).

Source: SEC Filings

With that being said, I am more so worried about the continued downshift in earnings potential from margin compression and sluggish future loan growth. Since both of those items are in something of a downshift relative to past performance (and pre-COVID potential), I would suggest any would be shareholders remain on the sidelines.

I make it a rule to not use being an acquisition target as being the main driver to the investment thesis. While HTBK very well could be a seller to a larger bank, I have a hard time getting excited about the core operations at this current above-peer valuation level.

Source: SEC Filings and Author's Estimates

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.