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It’s quite likely that the results that investors will see from bank stocks between this quarter’s reports and first or second quarter results will be as good as it gets. Not only are credit losses likely to rise from here and loan demand is likely to taper off on a weaker economy, but the cost of funding those loans is increasing significantly. On top of that, after years of cutting branches and trimming costs, there are relatively few levers to pull to drive better operating leverage.
Given where we are in the rate and business cycle, Michigan’s Mercantile Bank (NASDAQ:MBWM) has likely seen the best results it’s going to see until the Fed eases off its rate hikes. This sets up a challenging environment for the stock, as the shares aren’t expensive by most multiples-based approaches, but offer a less compelling case when factoring in sentiment and the long-term core growth that I expect from this bank.
Better Than Expected Results, Driven By Strong Spread Leverage
Mercantile management positioned the bank to profit significantly off of higher rates, and those rates are now driving strong growth in net interest income. While fee income has been pressured by a decline in mortgage banking, all in all this was a better-than-expected quarter, tempered by weaker guidance for 2023 as funding costs start to take a bigger bite.
Revenue rose 29% year over year and around 18% quarter over quarter, beating expectations by close to 9% (or $0.24/share). Revenue growth was driven spread income, with net interest income up almost 56% yoy and 20% qoq. This growth was driven by net interest margin (up 156bp yoy and 74bp qoq to 4.3%), as earning assets actually shrank slightly in the quarter (down 1.1%).
Non-interest income declined 38% year over year and rose close to 8% qoq. Sequential growth was driven by income from rate swaps, as mortgage banking continued to decline (down 76% yoy and 5% qoq) and other sources of income like service charges, card income, and treasury services can’t fill the gap.
Operating expenses fell 14% yoy and rose about 7% qoq. The year-over-year decline was helped by lower wages and charitable donations, though wages and donations did drive the sequential increase. Management indicated that they’re not planning on charitable donations for 2023, and I would expect to see some pressure from wage growth and higher expenses like FDIC insurance.
Pre-provision profits rose 153% yoy and about 31% sequentially, and though higher operating costs absorbed some of the leverage from higher revenue, core pre-provisions profits were still better than expected and drove the $0.17/share earnings beat.
Weaker Commercial Lending And Rising Deposit Costs
Loans rose 15% yoy and about 2% qoq on an average balance basis and 13% and 3% on an end-of-period basis, and there was a significant slowdown with the core lending numbers. Commercial and Industrial (or C&I) lending shrank more than 2% in the quarter; while small banks overall saw little growth in C&I lending in the fourth quarter, Mercantile underperformed that bar. Commercial real estate loan growth of 1.6% was likewise weak relative to nearly 3% growth for small banks in this category.
Where Mercantile did see loan growth was in the mortgage portfolio (up 7% qoq), but this was largely due to the bank taking mortgage originations onto the balance sheet given a weak market for the loans (the decline in mortgage banking).
Loan yields improved 93bp sequentially (to 5.49%), as the bank benefits from its strong skew toward commercial lending and adjustable/floating rate loans.
On the deposit side, balances declined 3.5% qoq (end of period) and 1.8% qoq (average balance), and the seasonal nature of the business usually sees weaker balances in the fourth quarter. Even so, Mercantile didn’t do badly relative to comps. Non-interest-bearing deposits barely declined sequentially on an average balance basis, but did decline more than 6% on an end of period basis.
Deposit costs rose 18bp qoq to 0.42%, which is still rather low on a comparable basis. Likewise, interest-bearing deposit costs increased about 35bp qoq to 0.78%, and both the rate of increase and absolute cost are lower than what investors are seeing from larger, better-known banks.
While Mercantile has seen a very low cumulative deposit beta (around 6%) and interest-bearing deposit beta (around 11%), funding further loan growth is going to come at a higher cost. The loan/deposit ratio is about 105% (EOP basis) and deposit-gathering is going to get more challenging. One positive is the nature of the company’s commercial-oriented operations – commercial lending is around 80% of the book and the company has a solid track record of getting commercial lending customers to move their deposit business (including low-cost operating accounts) to Mercantile. With management targeting around 5% commercial loan growth in 2023, bringing in new commercial customers could offer valuable relief on deposit costs.
The Outlook
Management’s guidance for 2023 came in weaker than hoped, and do indicate that the company has already seen peak net interest margin for this cycle. Management expects NIM to decline from 4.3% this quarter to 3.8% by the end of 2023, implying around 6% net interest income growth when factoring in the 7% to 9% forecast loan growth. between further weakness in non-interest income and low single-digit growth in expenses, pre-provision profit growth would appear to be only around 3% for the upcoming year.
Beyond the near-term rate challenges (and the weakness in the housing market), I do see opportunities for Mercantile to grow. Mortgage banking will recover in time and many banks have responded to this downturn by getting out of the business entirely. Many will no doubt reverse course when the market turns again, but Mercantile could gain some share by staying in the business. I am more bullish on the company’s efforts to grow its treasury services business (including payroll services), and I believe this could be an important driver over time if the company can tie these services to its commercial lending efforts.
As far as core lending goes, the bank continues to look to expand within Michigan and into select neighboring markets (like Cincinnati). While Michigan and surrounding markets don’t offer the sort of demographic growth that Southeast markets do, they also aren’t high-priority markets for most larger banks like Bank of America (BAC), Comerica (CMA), Fifth Third (FITB), and PNC (PNC) with sizable presences in the state.
With that, I could see Mercantile taking advantage of this comparative lack of competition, particularly with opportunities to take advantage of disruptive M&A that has taken place in the area (including deals driven by Huntington (HBAN) and New York Community Bancorp (NYCB)).
I’m expecting weaker earnings trends in FY’23 and FY’24; while Mercantile should be able to leverage the tailwinds from higher rates to grow earnings in FY’23, FY’24 could see contraction. I do expect a rebound in FY’25 and I’m looking for long-term core earnings growth around 4%. I do expect Mercantile to be a share gainer in its core markets, and a beneficiary of larger banks looking elsewhere for growth and smaller banks struggling to compete on service offerings.
Multiples-based approaches like ROTCE-driven P/TBV and P/E can support a fair value in the high-$30’s and it’s not hard to get a fair value in the low-$40’s. On a discounted core earnings basis, though, I think fair value is closer to the mid-$30’s and this is my primary valuation approach.
The Bottom Line
I don’t find today’s valuation for Mercantile demanding, but I do think there is a greater likelihood of weaker earnings in FY’23/FY’24 than stronger (relative to my current estimates), and I think sentiment will be a headwind so long as pre-provision profit growth is in the low single-digits (or worse). The dividend is solid and I think this name could have appeal to value investors with longer-term investing timelines, but I do have concerns that this could be more of a value trap in the shorter term.
