Independent Bank: Gradual Normalization Of Mortgage Banking Revenue Likely To Hurt Earnings (NASDAQ:IBCP)

Earnings of Independent Bank Corporation (NASDAQ: IBCP) surged in the third quarter on the back of a drop in provision expense and a rise in mortgage banking revenue. Earnings will likely trend downwards next year mainly because mortgage banking revenue will move towards normalization. On the other hand, lower provision expense and low loan growth will offer some support to the bottom line. Overall, I’m expecting IBCP to report earnings of around $2.27 per share in 2021, down from the estimated earnings of $2.48 per share in 2020. IBCP’s current market price is quite close to next year’s target price; hence, I’m adopting a neutral rating on the stock.

Mortgage Banking Revenue Likely to Decline Next Year as Rates Stabilize

IBCP’s mortgage banking revenue surged in the third quarter as the sharp cut in interest rates earlier this year triggered refinancing activity and new mortgage origination. IBCP reported mortgage banking revenue of $20.2 million in the third quarter of 2020, up from $5.7 million in the corresponding period last year. Mortgage banking revenue made up 34% of total revenue in the third quarter.

I’m expecting the mortgage banking market to remain robust over the next few months because mortgage rates reached a new low in the week ended November 20, according to news reports. Low rates will likely act as a catalyst for refinance activity and new mortgages for first-time homebuyers. Further, homebuilder confidence is at a record high, according to news sources, which suggests that demand for mortgage originations will likely remain high in the coming months.

However, I’m expecting volumes to start declining next year because rates will soon stabilize, thereby eliminating the benefit for homeowners who have already refinanced since March 2020. The management also mentioned in the third quarter’s conference call that it expects originations in 2021 to be lower than 2020 but above normal. Considering these factors, I’m expecting mortgage banking revenue to decline next year, leading non-interest income to dip by 9% next year.

Forgiveness of Paycheck Protection Program Loans to Drag Loan Book

I’m expecting loan growth in 2021 to be much lower than the historical average, partly because of the upcoming forgiveness of Paycheck Protection Program (“PPP”) loans. The company had $261 million worth of PPP loans outstanding at the end of the last quarter, as mentioned in the conference call. The management further mentioned that around 14% of PPP loan borrowers had applied for loan forgiveness approval by the time of the conference call (October 27, 2020). Based on the proportion of applications, I’m expecting a majority of the PPP loans to get forgiven next year, which will drag loan growth next year.

Moreover, the management mentioned in the conference call that its customers currently have a lot of liquidity amid the pandemic. Therefore, their demand for credit is low. Considering these factors, I’m expecting loans to increase by just 1% year-over-year in 2021, as shown in the table below.

Independent Bank Corporation Balance Sheet Forecast

Credit Risks Appear to Have Substantially Eased

IBCP’s credit risk has substantially eased in the third quarter as forbearances declined to 2.3% of the total loan portfolio from 4.2% of the total loan portfolio at the end of the second quarter, as mentioned in the third quarter’s investor presentation. However, some risk remains because of IBCP’s exposure to COVID-19 sensitive industries, including hotels, restaurants, and retail. Altogether, the vulnerable industries made up 9.8% of total loans at the end of the last quarter, as shown below.

Independent Bank Corporation COVID-19 Sensitive Industries

IBCP will adopt the new accounting standard for credit losses, called Current Expected Credit Losses or CECL, in the fourth quarter. The management mentioned in the conference call that its estimate for provisions under CECL and the incurred loss model was the same for the first nine months of 2020. Therefore, the adoption of CECL in the fourth quarter should not have much of an impact on provision expense. Nevertheless, the risk level remains above normal because of the accounting change.

IBCP made big reserve builds in the first half of the year, which will likely reduce the need for further sizable provisioning in the coming quarters. The provision expense in the first half of 2020 made up 42bps of total loans, which is much higher than the average provision expense of 5bps from 2017 to 2019. Considering these factors, I’m expecting the provision expense to decline by 46% year-over-year in 2021.

Expecting Earnings of $2.27 per Share in 2021

The drop in mortgage banking revenue will likely drag earnings next year. On the other hand, low loan growth and a decline in provision expense will likely support earnings. Overall, I’m expecting IBCP to report earnings of $2.27 per share in 2021, down 8% from my expected earnings of $2.48 per share for 2020. The following table shows my estimates for income statement items.

Independent Bank Corporation Income Forecast

Actual earnings may differ materially from estimates due to the uncertainties related to the COVID-19 pandemic.

Target Price Already Close to the Current Market Price

IBCP is offering a dividend yield of 4.7%, assuming the company maintains its quarterly dividend at the current level of $0.20 per share. There is little threat of a dividend cut because the earnings and dividend estimates suggest a payout ratio of just 35% for 2021. Apart from the dividend, IBCP is also likely to reward investors through share repurchases. The management mentioned in the conference call that it planned to start repurchasing shares in the last two months of this year.

I’m using the historical price-to-tangible book multiple (“P/TB”) to value IBCP. The stock has traded at an average P/TB ratio of 1.02 in the first nine months of 2020. Multiplying this P/TB multiple with the forecast tangible book value of $16.7 per share gives a target price of $17.1 for the mid of next year. This price target implies only a 0.9% upside from the November 20 closing price. The following table shows the sensitivity of the target price to the P/TB ratio.

Independent Bank Corporation Valuation Sensitivity

The current market price is close to next year’s target price, which shows that IBCP is already fairly valued. As a result, I’m adopting a neutral rating on IBCP.

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.

Additional disclosure: 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.

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