Thursday, December 1 2022

Takako Hatayama Phillips

Profit from Heritage Commerce Corp. (NASDAQ: HTBK) will most likely increase this year as high interest rates will boost the net interest margin. Additionally, the strengthening California economy will drive loan growth, which, in turn, will boost revenues. During this time, the provisioning will probably remain silent because Heritage has already set aside an excessively high amount for loan losses. Overall, I expect Heritage Commerce to report earnings of $0.99 per share for 2022, up 26% year-over-year. Compared to my last report on the company, I have increased my earnings estimate as I have revised my margin estimate upwards. For 2023, I expect Heritage Commerce to report earnings of $1.17 per share, up 18% year-over-year. The year-end target price suggests a strong upside from the current market price. Therefore, I maintain a buy rating on Heritage Commerce Corp.

Higher rates are the biggest catalyst for revenue growth

Previously, I expected interest rates to plateau after 2022. However, due to the recent upward revision of interest rate projections by the Federal Reserve, I expect rates to continue to rise next year, albeit at a slower pace than in 2022. I am now expecting the fed funds rate to rise 125 to 150 basis points through mid- June 2023, from the current level of 3.25%.

Fortunately for Heritage Commerce, net interest income is quite sensitive to changes in interest rates, according to the results of management’s interest rate sensitivity analysis in the 10-Q filing. A 200 basis point increase in interest rates could increase net interest income by 11.3% year-over-year.

Wealth Trade interest rate sensitivity

Heritage Commerce 2Q 2022 10-Q Deposit

This rate sensitivity is attributable to both the composition of loans and deposits. Approximately 36% of Heritage Commerce’s loan portfolio consisted of floating rate loans at the end of June 2022, as mentioned in the earnings release. As a result, the average return on earning assets is moderately rate sensitive. By comparison, the cost of deposits is quite rigid, as non-interest bearing deposits accounted for 40% of total deposits at the end of June 2022.

Given these factors, I expect the net interest margin to increase by 40 basis points in the second half of 2022 and then by ten basis points in 2023. Compared to my last report on Heritage Commerce, I ‘ve revised my margin estimate upwards because the Federal Reserve has become more hawkish than before on its monetary policy.

San Francisco economy to support loan growth

After declining in the first quarter, the loan portfolio jumped 1.9% (7.5% annualized) in the second quarter of 2022. Going forward, loan growth will most likely remain positive. Commercial and industrial (“C&I”) line utilization was only 28% at the end of June 2022, as mentioned in the press release. Therefore, there is plenty of room for growth in the C&I segment.

Heritage Commerce operates primarily in California with a focus on the San Francisco Bay Area. As shown below, the San Francisco Bay Area has a very low unemployment rate. This means that employees have more power in the labor market, which gives me hope that the demand for consumer loans and residential mortgages will remain high.

Unemployment rates in California and San Francisco

Y-Charts

In addition, the growth outlook for commercial loans is positive due to the economic recovery in the region, as indicated by the coincident index.

California Index of Coincidence

Federal Reserve Bank of Philadelphia

Given these factors, I expect the loan portfolio to grow by 1.25% each quarter through the end of 2023. In addition, I expect other balance sheet items to grow more or less in line with loans. The following table shows my balance sheet estimates.

EX18 FY19 FY20 FY21 FY22E FY23E
Financial situation
Net loans 1,859 2,511 2,575 3,044 3,113 3,272
Net loan growth 18.9% 35.1% 2.6% 18.2% 2.3% 5.1%
Other productive assets 973 1,180 1,635 2,054 1,947 2,046
Deposits 2,638 3,415 3,914 4,759 4,730 4,971
Loans and sub-debts 39 40 40 40 40 42
Common Equity 367 577 578 598 624 663
Book value per share ($) 8.7 12.0 9.6 9.9 10.2 10.9
Tangible BVPS ($) 6.4 8.1 6.5 6.9 7.3 7.9

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

Provisioning should remain below average

Provisions for loan losses currently appear quite excessive relative to non-performing loans. The ratio of provisions to non-performing loans stood at 1675.51% at the end of June 2022. Also from a historical point of view, the coverage is quite high. Provisions accounted for 711.26% of total non-performing loans at the end of June 2021. In addition, the overall credit risk of the portfolio will remain low as approximately 82% of the loan portfolio is made up of real estate loans.

Overall, I expect net provision expense to be approximately 0.15% of total loans (annualized) in each quarter through the end of 2023. In comparison, net provision expense was an average of 0.17% of total loans over the past five years.

26% revenue increase

The sharp increase in interest rates and the resulting expansion of Heritage Commerce’s net interest margin will drive earnings over the next year and a half. Additionally, provisioning is likely to remain subdued as the current level of allocations is quite excessive. Overall, I expect Heritage Commerce to report earnings of $0.99 per share for 2022, up 26% year-over-year. For 2023, I expect earnings to grow 17.7% to $1.17 per share. The following table shows my income statement estimates.

EX18 FY19 FY20 FY21 FY22E FY23E
income statement
Net interest income 122 132 142 146 173 201
Allowance for loan losses seven 1 13 (3) 2 5
Non-interest income ten ten ten ten 9 9
Non-interest charges 76 85 90 93 96 105
Net income – Common Sh. 35 40 35 48 60 71
BPA – Diluted ($) 0.84 0.84 0.59 0.79 0.99 1.17

Source: SEC filings, earnings releases, author’s estimates

(In millions of dollars, unless otherwise indicated)

In my last report on Heritage Commerce, I estimated earnings of $0.89 per share for 2022. I increased my earnings estimate primarily because I revised my net margin estimate upwards from interest.

Actual earnings may differ materially from estimates due to the risks and uncertainties associated with inflation and, therefore, the timing and magnitude of interest rate increases. Also, a deeper or longer than expected recession may increase the expected loan loss provisioning beyond my estimates.

Rising high prices call for a buy rating

Heritage Commerce offers a dividend yield of 4.4% at the current quarterly dividend rate of $0.13 per share. Earnings and dividend estimates suggest a payout ratio of 45% for 2022, which is below the five-year average of 66%. Heritage Commerce can easily afford to pay out more than half of its profits because it has more than enough capital. The company’s total capital ratio stood at 14.1% at the end of June 2022, compared to a minimum regulatory requirement of 10.5%. Therefore, there is certainly room for a higher dividend. However, to be on the safe side, I assume that the dividend will remain unchanged until the end of 2023.

I use historical price/earnings (“P/TB”) and price/earnings (“P/E”) multiples to value Heritage Commerce. The stock has traded at an average P/TB ratio of 1.72 in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
T. Book value per share ($) 6.4 8.1 6.5 6.9
Average market price ($) 15.7 12.3 8.3 11.2
Historical P/TB 2.44x 1.52x 1.28x 1.63x 1.72x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/TB multiple by the expected tangible book value per share of $7.3 yields a target price of $12.5 for the end of 2022. This price target implies an upside of 6.5% compared to the closing price on September 21. The following table shows the sensitivity of the target price to the P/TB ratio.

Multiple P/TB 1.52x 1.62x 1.72x 1.82x 1.92x
TBVPS – Dec 2022 ($) 7.3 7.3 7.3 7.3 7.3
Target price ($) 11.1 11.8 12.5 13.2 14.0
Market price ($) 11.8 11.8 11.8 11.8 11.8
Up/(down) (5.9)% 0.3% 6.5% 12.7% 18.9%
Source: Author’s estimates

The stock has traded at an average P/E ratio of around 15.5x in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
Earnings per share ($) 0.84 0.84 0.59 0.79
Average market price ($) 15.7 12.3 8.3 11.2
Historical PER 18.8x 14.6x 14.2x 14.2x 15.5x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/E multiple with the expected earnings per share of $0.99 yields a price target of $15.3 for the end of 2022. This price target implies a 30.3% upside from at the closing price on September 21. The following table shows the sensitivity of the target price to the P/E ratio.

Multiple P/E 13.5x 14.5x 15.5x 16.5x 17.5x
EPS – 2022 ($) 0.99 0.99 0.99 0.99 0.99
Target price ($) 13.3 14.3 15.3 16.3 17.3
Market price ($) 11.8 11.8 11.8 11.8 11.8
Up/(down) 13.5% 21.9% 30.3% 38.8% 47.2%
Source: Author’s estimates

Equal weighting of target prices from both valuation methods gives a combined result target price of $13.9, implying an 18.4% upside from the current market price. Adding the forward dividend yield gives an expected total return of 22.8%. Therefore, I maintain a buy rating on Heritage Commerce Corp.

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