HBMD: Disposition of Mortgage Operation, Continued Expense Reductions

HBMD: Disposition of Mortgage Operation, Continued Expense Reductions Lead to Greater Efficiency; Raising Target Price; Reaffirming Neutral Rating.

        Howard Bancorp, Inc. (HBMD – NASDAQ – Recent Intraday Price: $17.89)

                       Rating: Neutral / Buy Price: $15.00  / Target (Sell) Price: $17.00

4Q19 Results: Howard Bancorp reported a 4Q19 net income of $5.9 million, up 27.2% compared to 3Q19 net income of $4.6 million. This translates to EPS of $0.31 in 4Q19 compared to $0.24 in 3Q19. Included in 4Q19 results included $750k in noninterest revenue stemming from the sale of the company’s mortgage division to another company, discontinuing the bank’s mortgage operations. There was also a $339k elimination of a lease liability on a branch closed earlier in 2019. Included in 3Q19 results was a $700 legal settlement related to mortgages originated by First Mariner prior to its acquisition by HBMD. Excluding these nonrecurring items from both quarters, “adjusted” EPS was $0.27 in both 4Q19 and 3Q19. Adjusted 4Q19 results exceeded our $0.25 estimate by $0.02 and the $0.26 median Street estimate by a penny. The quarter was characterized by lower-than-expected net interest income, offset by higher than expected “core” noninterest revenue, lower “core” noninterest expense, and a lower effective tax rate.

Highlights from the quarter include:

· Net interest income was $17.3 million in 4Q19, up 0.3% compared to the prior sequential quarter. Average earning assets climbed 2.8% from the prior quarter while the NIM contracted 8 basis points sequentially to 3.38%. Purchase accounting accretion contributed 7 bps to the NIM this quarter, the same as the prior quarter. However, the main driver of the NIM contraction was a 15 bps decrease in the average yield on loans, coupled with a 22 bps decline in average securities yields. This drove a 21 bps reduction in average earning asset yields. Meanwhile, the cost of interest bearing liabilities was down 14 bps compared to 3Q19, as a 7 bps drop in the average cost of deposits combined with a 36 bps drop in the cost of short-term borrowings and a 359 bps reduction in long-term borrowing costs.

· Noninterest income rose $0.6 million or 11.8% linked-quarter to $5.6 million. The increase resulted mainly from the previously mentioned $750k received in relation to the sale of the bank’s mortgage operations. Absent this item, “core” noninterest income fell by only $158k or 3.1%, driven by a $176k reduction in mortgage related revenues.

· Noninterest expenses decreased $1.0 million or 6.8% sequentially. The previously mentioned $700k charge for a legal settlement in the prior quarter and the $339k lease liability reduction in 4Q19 accounted for essentially all of the sequential change. Absent these irregular items, “core” noninterest expense was essentially flat with the prior quarter, as an increase in marketing expenses was essentially offset by reductions in employee compensation and occupancy expenses (excluding the lease liability reduction).

· The provision for loan losses in 4Q19 was $750k, up 23.4% compared to 3Q19, almost matching the $752k we had projected. The bank experienced a small recovery of previous charge-offs of roughly $53k or (0.01)% of average loans during the quarter, compared to $479k or 0.11% of average loans in 3Q19. The loan loss reserve advanced $0.8 million or 8.4% from the prior quarter. Reserve coverage of total loans advanced to 0.60% from 0.55% at September 30, 2019, while reserve coverage of NPLs grew to 54.3% from 48.1%.

· OREO decreased $0.8 million or 21.1% to $3.1 million in 4Q19, while nonperforming loans also fell $0.7 million or 4.0%. Total NPAs (including performing TDRs) retreated 6.9% LQ to 0.94% of total assets from 1.04% at September 30, 2019.

· Gross loans held-for investment climbed $15.6 million or 0.9% from the prior quarter, down from growth of 1.7% in 3Q19. Though growth was hampered by the payoff of one large $25 million loan during the quarter and the shift of two loan closings into early January, Howard recorded commercial loan originations of roughly $70.5 million in 4Q19, up from $50.0 million in 3Q19. Total loan originations in 4Q19 were $94.8 million.

· Total deposits advanced $58.7 million or 3.5% in 4Q19. This exceeded the $15.6 million growth in gross loans held-for-investment. The excess funding was deployed primarily in AFS securities. The loans-to-deposits ratio fell to 101.8% from 104.5% at September 30, 2019.

· Tangible book value per share rose to $12.57 at December 31, 2019 from $12.24 at September 30, 2019. Tangible common equity-to-tangible assets was 10.43% at December 31, 2019 compared to 10.53% at September 30, 2019.

· The total risk-based capital ratio rose 27 bps sequentially to 13.14% while the Tier 1 leverage ratio climbed 16 bps to 9.55%. All of the regulatory ratios remain well above the levels needed to be considered “well capitalized”.

· The company purchased 14,864 shares in 4Q19 under its current $7 million repurchase program that expires in December 2020. This brings the total to 19,764 shares repurchased in 2019. As of January 21st, 2020, another 49,041 shares had been purchased, marking an acceleration of the repurchase effort. With roughly $1.3 million of the $7.0 million authorization spent so far, this leaves somewhere in the neighborhood of 320,000 shares that could still be purchased at current prices. We expect management to continue buying shares back at the current pace set so far in January 2020, and we have included such purchases in our model.

Earnings Estimates:

Howard produced strong 4Q19 results, with significant asset quality improvement, modest NIM compression, solid loan growth despite the headwinds of a large payoff and the slippage of some loan closings, and strong deposit generation. The company also disposed of its mortgage origination unit during the quarter, which will reduce EPS minimally while allowing the company to focus on its core commercial business and improve efficiency. The company also continued to make progress on expense reduction initiatives such as branch consolidations and a core systems conversion. Some of the fruits of these efforts were evident in 4Q19 results, but the cost reductions should continue into 1Q20 and 2Q20.

We still anticipate loan growth in the 6%-8% range for 2020. Deposit growth should be aided by the recent addition of three new staff additions coming from consolidating competitors that will be focused on generating deposits. Still, we anticipate that deposit growth will trail loan growth by 1%-2%. We expect some additional modest NIM compression of 2-3 bps over the next few quarters before the NIM stabilizes. We have reduced the share count in our model to reflect accelerated share repurchases. We have also removed the revenues and expenses attributed to the mortgage operations.

After making these adjustments, we are reducing our 2020 EPS forecast from $1.01 to $0.99, mainly reflecting the absence of the modest profits of the mortgage operation. We are raising our 2021 estimate from $1.14 to $1.15.

Valuation:

HBMD is currently trading at 20.3x trailing twelve month EPS and 144.0% of TBV. Peer valuations currently stand at 12.4x trailing twelve-month EPS and 132.8% of TBV. We still believe that HBMD can produce low- to mid-double digit EPS growth over the next few years. While we have been using an EPS multiple for valuing HBMD stock, we recognize that a TBV multiple would provide a significantly different valuation. Using a 14.0x EPS multiple applied to the $0.99 EPS projected over the next four quarters (1Q20-4Q20) results in a $14.00 target. However, using a 135% TBV multiple and applying it to the $14.00 TBV we are projecting at December 31, 2020 generates an $19.00 number. Consequently, we are now using a blended valuation approach to arrive at a $17.00 target, a $1.00 increase from our prior target. Still, with the stock currently trading above this target, we are reaffirming our Neutral rating on HBMD shares.