FDVA: Loan and Deposit Growth Disappoint, Funding Mix Improves; Reducing EPS Estimates; Raising Target Price; Reaffirming Neutral Rating.

        Freedom Bank of Virginia (FDVA – OTCQX – Recent Price: $10.57)

                       Rating: Neutral / Buy Price: $10.00 / Target (Sell) Price: $11.00

4Q19 Results:

Freedom Bank of Virginia reported 4Q19 net income of $748k, compared to the $932k posted in 3Q19 and the $15k recorded in the year-ago period. This translates to 4Q19 earnings per share of $0.10 compared to $0.13 in 3Q19 and $0.00 in 4Q18. The posted results exceeded our $0.09 EPS estimate by a penny. Lower-than-expected noninterest expenses and a lower loan loss provision offset greater-than-expected NIM compression, and lower-than-expected noninterest income. Highlights from the quarter include:

· Gross loans held-for-investment declined $7.9 million or 2.0% sequentially to $392.9 million. Loans held for sale also fell, retreating $7.7 million or 39.7% linked-quarter. The declines follow two consecutive quarters of significant loan growth. All loan segments experienced declines during the quarter, with the biggest percentage decreases coming in construction, consumer, and residential real estate, which fell 15.8%, 7.5%, and 5.2%, respectively, compared to 3Q19. Management notes high levels of payoffs during the quarter as a significant contributor to the loan declines. However, we still expect loan growth to proceed at a high-single digit annual pace going forward.

· Freedom continues to increase its on-balance sheet liquidity, growing low-yielding interest bearing deposits with other financial institutions by $4.1 million or 20.1% linked-quarter. At the same time, the bank’s AFS investment portfolio increased $4.9 million or 10.8%. However, these increases were not sufficient to overcome the declines in loans, so the end result was a $7.0 million or 1.4% sequential decrease in total assets.

· Total deposits fell $1.4 million or 0.4% sequentially. Noninterest bearing accounts declined $0.3 million or 0.4% sequentially, while money market & savings deposits fell $3.1 million or 3.1% and time deposits decreased $3.0 million or 1.5% sequentially. Partially offsetting these movements was a $16.9 million rise in interest bearing demand deposits. Since total assets fell more than total deposits, Freedom was able to reduce FHLB advances, which fell $6.0 million or 14.3%. Overall, the mix of funding improved, but the mix of interest earning assets was not so favorable.

· Net interest income decreased $172k or 4.1% linked-quarter, as a 1.2% advance in average earning assets was overcome by 18 bps of NIM compression to 3.33% (on a tax equivalent basis) to drive the decline. The yield on average earning assets fell by 18 bps sequentially, driven by a 16 bps drop in average loan yields and a 47 bps slump in average securities yields. Contributing to the fall in loan yields was the absence of interest recognized on a loan recovery that contributed roughly 10 bps to loan yields in the prior quarter. Meanwhile, the cost of interest bearing liabilities dipped 9 bps on a 7 bps drop in average interest bearing deposit costs and a 24 bps decline in the average cost of borrowings. The funding mix experienced a minor favorable change as a result of the modest growth in average noninterest bearing demand deposits, offset slightly by growth in FHLB borrowings. FDVA still has a relatively high cost of interest bearing liabilities, and we expect the recent Fed rate cuts to lead to further reductions in funding costs as CDs and FHLB borrowings mature and get replaced by lower cost deposits.

· Noninterest income decreased $596k or 32.5% compared to 3Q19, falling to $1.2 million. The primary driver was a $605 drop in mortgage banking revenues, following a $535k increase in the prior quarter.

· Noninterest expenses decreased $588k or 12.0% sequentially. Much of the drop stemmed from the decreased mortgage banking activity, as mortgage commission compensation helped drive a $426k or 13.9% retreat in employee compensation, and a $112k or 35.9% fall in mortgage fees and settlements. A $125k decline in “other” noninterest expenses also contributed to the overall drop in noninterest expenses.

· Freedom posted net charge-offs of $381k in 4Q19 compared to net recoveries of prior period charge-offs of approximately $20k in 3Q19. This translates to roughly 0.37% of average loans in 4Q19 compared to (0.02)% in 3Q19. Despite the jump in net charge-offs, Freedom did not record a loan loss provision in 4Q19 after posting a $47k provision in 3Q19.

· Freedom showed a substantial decrease in nonperforming loans in 4Q19. Nonaccrual loans fell roughly $484k or 22.2% sequentially. There were no performing TDRs and the company’s balance sheet remained free of OREO at December 31, 2019. However, loans 90 days past due and still accruing rose $3.9 million or 656.6% sequentially. The increase was largely related to two large credits where management feels there is adequate security and the collectability of delinquent payments is considered likely. At the same time, early stage delinquencies (loans 30-89 days past due) declined $5.1 million or 83.8% sequentially. As a result, NPLS/Loans fell from 0.52% at September 30, 2019 to 0.42% at December 31, 2019. NPAs/Assets (including 90-days past due) jumped from 0.55% at September 30, 2019 to 1.24% at December 31, 2019. The loan loss reserve slipped to 1.05% of total loans at December 31, 2019 from 1.12% at September 30, 2019.

· FDVA’s regulatory capital ratios improved modestly compared to the prior quarter-end. The Total capital ratio, Tier 1 ratio and CET1 ratio all advanced 40 bps-47 bps, while the Leverage ratio held steady at 12.80%. All of the regulatory capital ratios remain far above the minimum levels needed to be considered “well capitalized”.

· The tangible common equity ratio climbed to 12.80% at December 31, 2019 from 12.45% at September 30, 2019. Meanwhile, tangible book value per share climbed to $8.87 from $8.76.

Earnings Estimates: Despite beating our EPS expectations by a penny, 4Q19 results were somewhat disappointing. The decline in loans was unexpected. Management points out that significant payoffs during the quarter, some driven by lower interest rates and some due to aggressive competitive offerings, had a big impact on loan growth. We still expect the recent additions of experienced personnel from larger institutions to begin contributing more noticeably to loan growth over the course of the next few quarters. However, we have adjusted our loan growth estimates down slightly, as we suspect some of the factors affecting 4Q19 growth will linger into 1Q20. Though deposit growth was also disappointing, the mix of deposits and other funding sources improved.

In regard to the NIM, we believe that the impact of excess liquidity, loan payoffs and some residual impact from the last few Fed rate cuts will cause additional declines in earning asset yields in 1Q20 and into 2Q20. However, the improved funding mix and continued runoff or repricing of higher cost CDs, along with the ongoing reactions to the last few Fed rate cuts, will drive an even bigger reduction in funding costs. As a result, we are expecting a relatively stable NIM in 1Q20 and a few bps of BIM improvement over the following quarters. Asset quality remains good overall. The one cautionary note from 4Q19 results, the jump in past due 90-day loans, was largely a matter of getting paperwork signed and submitted, rather than deterioration in credit. Consequently, we have lowered our projections for the loan loss provision in 2020.

After making the preceding adjustments to our model, we are reducing our 2020 EPS estimate to $0.36 from $0.43, while lowering our 2021 EPS estimate to $0.43 from $0.46.

Stock Price Implications: The benefits of the Bank’s restructuring efforts were a bit harder to pinpoint in 4Q19 results, particularly in terms of loan and deposit growth. However, we still believe the company’s renewed focus, the addition of new personnel, and the beneficial shift in funding mix will help improve profitability over the next few years.

Publicly traded banks in Virginia with assets between $300 million and $1.0 billion are currently trading at median multiples of roughly 117.9% of TBV and 12.1x trailing twelve-months EPS. FDVA is trading at 119.6% of TBV while its P/E multiple is 28.6x. We believe that FDVA is on a path toward growth and profitability levels that approach peer levels, but there is still considerable work to do before reaching that goal.

For valuing FDVA stock, we are using a 120.0% P/TBV multiple, which is similar to its current valuation and up from the 115.0% multiple we had been using. Applied to the $9.09 TBV we are projecting at December 31, 2020, this multiple generates an $11.00 12-month target price, a $1.00 increase from out previous target. This target suggests a potential gain of 4.1% from the current price. As a result, we are reaffirming our Neutral rating for shares of FDVA.