Freedom Bank of Virginia reported 2Q20 net income of $1.5 million, up 79.5% compared to the $850k posted in 1Q20 and 199.7% over the $509k recorded in the year-ago period.
This translates to 2Q20 earnings per share of $0.21 compared to $0.11 in 1Q20 and $0.07 in 2Q19. The posted results exceeded our $0.16 EPS estimate by $0.05. Higher gains on the sale of mortgage loans and higher net interest income more than offset a higher loan loss provision and higher-than-expected noninterest expenses to generate the outperformance relative to our projection.
Highlights from the quarter include:
- Gross loans held-for-investment advanced $11.4 million or 27.7% sequentially to $513.8 million. Loans held-for-sale climbed $2.4 million or 8.0% linked-quarter. The main driver of the growth in loans held-for-investment was the $104.6 million in PPP loans originated during the quarter. However, even if we exclude these loans, the bank achieved sequential loan growth of a healthy 1.7%. The biggest contributor excluding PPP loans was the CRE segment, which rose $16.4 million or 7.6% sequentially. The construction segment also grew during the quarter, rising $1.9 million or 12.7%. The CRE advanced $99.0 million or 11.4%, pushed mainly by the PPP loans. Meanwhile, the residential mortgage and consumer segments declined 2.9% and 8.1%, respectively. Once again, the COVID-19 pandemic has caused us to reduce our expectations for organic loan growth modestly to a mid-single digit pace from our prior mid- to high-single digit pace.
- Despite the big increase in loans, Freedom’s asset mix became less favorable in 2Q20, as low- yielding interest bearing deposits with other financial institutions and the bank’s AFS investment portfolio grew faster than loans. As a result, loans declined to 78.3% of total assets from 80.6% at the prior quarter-end. Total assets increased to $697.2 million, a $160.9 million or 30.0% sequential increase from 1Q20.
- Total deposits climbed $75.3 million or 18.2% sequentially. Noninterest bearing accounts advanced $68.9 million or 81.1% sequentially, while interest bearing demand deposits rose $4.7 million or 28.5% and money market & savings deposits increased $11.0 million or 9.0% sequentially. Partially offsetting these movements was a $9.4 million or 4.9% decline in time deposits. The growth in deposits was supplemented by $104.7 million in PPP Liquidity Facility funds. The combined increase in deposit and PPPLF funding was more than enough to provide for the growth in PPP and other loans, leading to the increased liquidity and similar to the growth in loans held-for-investment, leading to the growth in lower-yielding securities and other liquid assets.
- Net interest income increased $742k or 18.7% linked-quarter, as a 32.1% advance in average earning assets was more than enough to overcome 33 bps of NIM compression to 2.93% (on a tax equivalent basis). The yield on average earning assets fell by 80 bps sequentially, driven by a 67 bps drop in average loan yields, 11 bps in average securities yields, and the previously noted shift in the earning asset mix away from loans and toward lower yielding cash and securities. The inclusion of low yielding PPP loans (which carry an interest rate of 1.0%) to the mix played a significant part in the reduced loan yields. However, origination and servicing fees on these loans of up to 5.0% are amortized over the life of these loans. If many of these loans are forgiven over the next two to three quarters, as we expect, the accelerated fee accretion will boost the yields recognized on these loans substantially. Meanwhile, the cost of interest bearing liabilities dipped 57 bps on a 46 bps drop in average interest bearing deposit costs and an 82 bps decline in the average cost of borrowings. The reduced borrowing costs were driven by the PPPLF funds, which carry a cost of 0.35%. We still anticipate further reductions in funding costs as CDs and FHLB borrowings mature and get replaced by lower cost deposits.
- Noninterest income increased $0.9 million or 37.7% compared to 1Q20, rising to $3.3 million. The primary driver was a $789k rise in mortgage banking revenues, offset partially by lower securities gains and “other” noninterest income.
- Noninterest expenses increased $580k or 12.0% sequentially. Much of the rise occurred in employee compensation, which climbed $231k or 7.1% sequentially driven by higher mortgage commission compensation. Mortgage fee settlement costs also increased, rising $233k or 105.5% LQ due to higher refinance activity. Professional fees rose $44k sequentially due to PPP related activity, while data processing fees climbed $99k, driven by higher loan and deposit activity.
- Freedom recorded net charge-offs of $150k or 0.12% of average loans, compared to no net charge-offs in 1Q20. As a result of the charge-offs, loan growth, and deteriorating economic conditions related to COVID-19, Freedom recorded a $705k loan loss provision in 2Q20. Freedom reported that it has agreed to payment deferrals of up to six months for 96 borrowers (up from 81 as of March 31, 2020) on loans totaling $89 million in response to the pandemic.
- Nonperforming loans grew roughly $1.8 million or 84.1% in 2Q20. There were no performing TDRs and the company’s balance sheet remained free of OREO at March 31, 2020. Meanwhile, loans 90 days past due and still accruing fell $70k or 46.7% sequentially. At the same time, early stage delinquencies (loans 30-89 days past due) declined $254k or 8.0% sequentially. As a result, NPLS/Loans rose from 0.50% at March 31, 2020 to 0.90% at June 30, 2020 (0.71% if we include PPP loans). NPAs/Assets (including 90-days past due) climbed from 0.43% at March 31, 2020 to 0.58% at June 30, 2020. The loan loss reserve climbed to 1.28% of total loans (excluding PPP loans) at March 31, 2020 from 1.16% at March 31, 2020.
- FDVA’s regulatory capital ratios declined noticeably compared to the prior quarter-end. The Total capital ratio, Tier 1 ratio and CET1 ratio all retreated 39 bps-45 bps, while the Leverage ratio fell 165 bps to 11.23%. All of the regulatory capital ratios remain far above the minimum levels needed to be considered “well capitalized”.
- The tangible common equity ratio dropped to 9.69% at June 30, 2020 from 12.17% at March 31, 2020. Meanwhile, tangible book value per share climbed to $9.33 from $9.02.
Earnings Estimates:
The COVID-19 pandemic and the related reduction in economic activity has been longer and deeper than we had anticipated three months ago. There are no signs that it is getting better or that we can put it behind us until vaccines become widely available, hopefully early in 2021. Even then, the damage to many households and small businesses is likely to persist for years to come. We believe that FDVA’s geographic location – in the suburbs of Washington DC – and its heavy concentration in commercial clients, particularly government contractors, will mitigate some of the unfavorable effects of the pandemic. Still, we expect loan organic growth to fall short of the reductions in PPP loans over the next three or four quarters and asset quality deterioration to increase as deferral periods end. We have boosted our estimate for loan loss provisioning accordingly and reduced our estimates for loan growth. The bank has substantial liquidity due to strong deposit inflows and the use of the PPP Lending Facility, both of which contributed to a sharp drop in funding costs. We expect both funding sources to decline in coming quarters as PPP loans are forgive or repaid and as borrowers utilize any excess funds sitting in deposit accounts. This will offset any ongoing benefits from reductions in the pricing and volume of time and brokered deposits. While the loss of low-yielding PPP loans due to forgiveness and the accelerated accretion of fees associated with these loans will boost average asset yields over the next several quarters, we still expect ongoing drops in average rates on new loan originations and repricings to continue pressuring the NIM. Mortgage banking revenue has been strong in recent quarters, aided by solid purchase and refinance activity. We don’t see any signs of this slowing yet, but we are projecting some reduction in volumes in 4Q20.
After making the preceding adjustments to our model, we are reducing our EPS estimates for 3Q20 and 4Q20, but maintaining our $0.65 estimate for the full year, reflecting the better-than-expected 2Q20 results. We are raising our 2021 EPS estimate to $0.50 from $0.47 and introducing a 2022 estimate of $0.54.
Outlook:
WE anticipate a tough interest rate environment over the next year or two and an increase in problem loans, leading to changes to our NIM projections and loan loss provision expectations. Still, we believe Freedom’s geographic location and commercial emphasis will serve the bank well and help it perform better than many similar small banks throughout the country.
FDVA currently trades at only 77.7% of tangible book value. This valuation is in-line with similar-size peer banks in the region. However, as we note above, we believe that Freedom has a good chance to outperform these peer institutions due to its location, its business focus, and the recently completed restructuring of the bank that has boosted results in recent quarters, making this an attractive investment.
Due to changes in our corporate structure and a desire to avoid conflicts of interest, we are discontinuing the practice of providing target prices and stock ratings in our reports. However, we still believe we have insights to offer and value to add for the small number of securities that we continue to provide research coverage for.