Northrim BanCorp: Valuation Looks Appealing, Even With A Softer Mortgage Outlook
- A combination of both softer mortgage revenue and continued margin compression likely drives lower earnings.
- Credit looks likely to be better than consensus expectations.
- Future earnings are likely to drift lower and be more in line with peers, however, the current valuation discount paints an overly draconian picture.
When most people hear the term “community bank” they generally think of the local bank down the street. Whether that is the bank they use, or just a bank happen to drive by everyday, they know of it and understand what it does, even without being a customer. With that as a backdrop, when it comes to banking, most everyone knows the major domestic players, and a good portion know of the Hawaiian banks, but very few have heard of Anchorage, Alaska based Northrim BanCorp (NASDAQ:NRIM).
When it comes to the breakdown of the actual company, NRIM is structed like most of its peers. Northrim is technically a $2.1 billion asset bank holding company for Northrim Bank. Within NRIM there are two main components, Home Mortgage banking and Community Banking.
While I am bullish on the stock, largely due to its relatively cheap valuation and stronger than average earnings profile, I do think it would make some sense to investigate the loan portfolio. At the end of last year, the smallest portfolio of the portfolio was consumer loans (at just 3% of loans). Construction lending comprised 8%, while owner occupied commercial real estate made up another 11%. The two major portions of the bank's loan portfolio were non-owner occupied commercial real estate (at 24%) and commercial and industrial loans (the remaining 54%).
While construction tends to have higher embedded loss content, NRIM's loan portfolio appears to be relatively conservative. While commercial real estate tends to carry lower yields, they are usually have lower credit risk. However, it should also be noted that PPP loans make up nearly 20% of the entire lending portfolio and will be a headwind to growth in the coming quarters.
In my mind, the most exciting thing investors should keep a keen eye on is the cheap valuation. While most continental, lower-48 state peer banks are trading closer to 1.65x price to tangible book value per share, NRIM is trading at 1.4x. To me, the strong earnings profile and nearly 4.00% net interest margin should not only justify a peer-like valuation but would also justify a premium if it were not for past credit issues. While credit issues were a major problem in the last recession, the limited problem loans today give the semblance that NRIM has turned the page in terms of its credit underwriting.
From a quick look at the graph below, one can see that its past credit history is less than ideal. While most banks experienced a pretty painful charge-off scenario in the last recession (of around 2.00% of average loans), NRIM had more than double its peers banks at its worst (4.05% of average loans).
Source: SEC Filings
While its impossible to confirm, in my mind, the credit problems from the last decade are likely one of the two major reasons why NRIM is lagging peers in terms of valuation. When thinking back over the past couple quarters, when the COVID vaccine was announced, banks with the strongest earning profiles rallied the most. It did not matter about the past credit problems, in fact it actually helped because of the (then current) cheap valuations.
While NRIM's credit profile appears to be improving, I think the stock is likely to see some relative headwinds as it will likely be a “prove it” story throughout the year. By that I mean for each additional quarter of credit improvement, the bank is likely to continue its grind higher. Without marked improvement, it likely treads water. While a bit frustrating for current shareholders (because it takes longer), I think it actually opens the door for new investors to add shares over time.
Source: SEC Filings
From the most recent earnings report, nonperforming assets improved to just $16.3 million, down from $17.9 million in the third quarter of 2020. Also, classified loans followed a similar path, down to $12.8 million, from $14.5 million. As one can see from the chart above, criticized loans continue to work lower too. All of these are net positive credit events, which cause me to scratch my head about the dramatically lower than peer valuation.
Finally, I think investors should know about the COVID sensitive lending categories. From the last earnings report, management specifically called out:
Northrim had $78.9 million, or 7% of portfolio loans, in the tourism sector; $56.1 million, or 5% of portfolio loans, in the aviation (non-tourism) sector; $96.9 million, or 8% of total portfolio loans, in the healthcare sector; $37.2 million, or 3% in the accommodations sector; $17.4 million, or 2% in retail loans; and $31.0 million, or 3% in the restaurant sector, as of December 31, 2020.
Over the next few quarters these COVID sensitive areas are likely to matter less, and the valuation should continue to improve. That said, these lending categories are on softer economic footing and could cause some trepidation for new generalist investors entering the space.
Revenue Analysis and Outlook
While 2020 is likely to prove to be a banner year, due to the combination of both strong mortgage operations coupled with a healthy loan production year, I think future earnings should keep its “above average” status. Just for reference, in the fourth quarter, NRIM reported an ROA of 1.9% and ROE of 18.2% - nearly double that of peer banks.
While the mortgage operation is likely to slow in the coming quarters as rates continue to move higher, I think the first half of 2021 should continue to support strong earnings. When looking at its mortgage operations as a whole, it does generate quite a bit of positive earnings due to excessive volume. However, mortgage is typically not a very efficient business, especially when compared to core lending operations. So, when mortgage business slows, it doesn’t cause a lock-step downshift in earnings.
From a core banking perspective, I think spread revenue is likely to come down a little a the margin grinds lower. In my opinion, NRIM has an unsustainably high margin today, however, I do believe that it will trickle lower rather than gap lower. This continued slid lower is likely to be driven by two things - delayed CRE loan repricing and one-time PPP loan forgiveness related fee income.
Going forward, the income statement likely follows suite to the credit analysis of being a “prove it” story. After each quarter NRIM is going to get more of a “re-review” since the margin is likely to continue to fall. If results are better than pre-earnings expectations, I think the bank’s stock price performs well. In my mind, I was being as conservative as possible in my modeling, yet I still come up with a slightly stronger than peer profitability outlook which should justify (at a minimum) a peer-like valuation.
Source: SEC Filings and Author's Estimates
When you combine both the softer mortgage operations and tepid margin, FY21 core earnings are likely to be lower than last year. When thinking about the year as a whole, I believe NRIM is going to produce a 1.2% ROA, which compares to 1.6% produced in FY20. While this profitability reduction is clearly not a positive, it does get the bank to being more inline with what peers are likely to see in FY21. In my mind, this should warrant a peer like valuation rather than 0.25x price to tangible book value discount.
While I understand that it is hard to give a premium valuation to a bank that is likely going to face noticeable earnings headwinds, the current discount to peers is excessive.
When thinking about FY21 as a whole, I think NRIM’s stock is likely to see a choppy trading pattern throughout the year. Since future earnings are likely to be lower than last year, I think each individual quarterly result is like to hold more weight than peer banks (which are trending upward).
While its hard to imagine a dramatic free fall in earnings, I do think the relative discount to peers today sets the stage for limited underperformance to peer banks. The banking sector itself has seen a dramatic move higher over the past year. While most banks are not likely to see dramatically improved earnings to match their relative valuation improvements, I think NRIM is currently mispriced compared to peers.
In conclusion, I believe NRIM is likely to outperform bank peers. While its unlikely to grind higher continually throughout the year, I do believe most of its outperformance will come right after its reported quarterly results. Alaska is notoriously hard to forecast economically, but NRIM has proven itself to be a solid operator these past few years. When thinking over the long-term, I believe NRIM is likely to continue to grow and use its capital well, supporting my bullish long-term view.
Source: SEC Filings and Author's Estimates
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