Bank OZK (NASDAQ:OZK) reported earnings of $0.39 per share in the second quarter, compared to $0.09 per share in the first quarter of 2020. The earnings improvement was chiefly attributable to a drop in provision expense. Earnings will likely continue to improve in the remainder of the year because the provision expense is likely to continue to decline. Moreover, gains on the sale of branches and higher average earning assets will likely drive earnings in the remainder of the year. Consequently, I’m expecting earnings to increase by 2.8x in the second half of the year compared to the first half. For the full year, I’m expecting OZK to report earnings of $1.80 per share, down 45% from last year. The June 2021 target price suggests only a 5% upside from the current market price. The limited upside shows that the market has already priced-in the prospects of earnings recovery; hence, I’m adopting a neutral rating on OZK.
Provisions Expense to Decline on the Back of Economic, Company-Specific Factors
OZK reported a provision expense of $72 million in the second quarter, down from $118 million in the first quarter of 2020. The management based the provisioning on forecasts for economic variables, including GDP, unemployment rates, and commercial and residential real estate prices, as mentioned in the second quarter’s 10-Q filing. The economic outlook has remained unchanged since the end of the second quarter, and I’m not expecting the economic outlook to deteriorate any further. Therefore, the provision expense will likely trend downwards over the next few quarters.
OZK felt the need to modify only 5% of total loans amid the COVID-19 pandemic, as mentioned in the 10-Q filing. Additionally, OZK has limited exposure to pandemic sensitive industries. Vulnerable industries from the commercial real estate segment made up 10% of total loans at the end of the last quarter, according to details given in the 10-Q filing.
Considering the economic and company-specific factors, I’m expecting the provision expense to sequentially decline in the year ahead. For the full year, I’m expecting OZK to report a provision expense of $240 million in 2020, up from $26 million in 2019.
Higher Average Earning Assets to Drive Net Interest Income
OZK’s loan balance surged by 5.6% quarter over quarter in the second quarter partly due to the Paycheck Protection Program, PPP. As mentioned in the 10-Q filing, OZK funded $462 million of loans under PPP.
Loans will likely remain almost constant in the year ahead as reduction of loans from PPP and the branch sale will likely cancel out organic growth. I’m expecting most of the PPP loans to get forgiven during the fourth quarter. Moreover, OZK is planning to shut down four branches by the fourth quarter, as mentioned in the second quarter’s management’s comments. These branches have loans of $33.3 million and deposits of $223.4 million. As loans will likely remain constant in the year ahead from the June-end level, the average earning assets in the second half of the year will be around 3.8% higher than the average for the first half. The following table shows my estimates for loans, deposits, and other balance sheet items.
OZK’s NIM declined by 22bps in the second quarter, on fully-taxable equivalent basis, following the 150bps federal funds rate cuts in March. The NIM will likely continue to decline in the year ahead as maturing assets and origination of new loans at lower rates will pressurize yields. A majority of OZK’s loans are variable-rate based, according to details given in the management’s comments. However, 92% of the funded balance of total variable rate loans were at floors at the end of the last quarter, which will mitigate the pressure on yields. Moreover, the maturities of costly Certificates of Deposits, CDs, will limit the NIM decline. As mentioned in the management’s comments, around $4.9 million of CDs will mature in the year ahead, representing 23% of total deposits. The following table from the management’s comments shows the maturity schedule of CDs in the remainder of 2020 and 2021.
Considering the factors mentioned above, I’m expecting NIM to decline by 2bps in each of the remaining two quarters of the year. For 2021, I’m expecting NIM to decline by 13bps.
Expecting Earnings to Sharply Recover in the Remainder of the Year
The sequential decline in provision expense and higher earning assets will likely drive earnings in the second half of the year. Moreover, the management expects the sale of branches to result in gains of $7 million to $9 million in the fourth quarter, as mentioned in the management’s comments. Consequently, I’m expecting earnings to increase by 2.8x in the second half compared to the first half of the year. For the full year, I’m expecting OZK to report earnings of $1.80 per share, down 45% from last year. The following table shows my income statement estimates.
Limited Upside Shows that the Prospects of Earnings Recovery are Priced In
I’m using OZK’s average price-to-tangible-book value multiple, P/TB, of 0.89 for the first half of 2020 to value the stock. Multiplying the June 2021 forecast tangible book value per share of $28.0 with the average P/TB multiple gives a target price of $24.9 for the mid of next year. This target price implies an upside of just 5% from OZK’s August 24 closing price. The following table shows the sensitivity of the target price to the P/TB multiple.
Apart from the price upside, OZK is also offering a dividend yield of 4.5%, assuming a quarterly dividend of $0.2725 per share. The bank usually increases its dividend per share by a cent or less every quarter, but to be conservative, I’m assuming that OZK will maintain its dividend at the current level through 2021. There is very little threat of a dividend cut because the earnings and dividend estimates suggest a sustainable payout ratio. The estimates imply a payout ratio of 40% for the fourth quarter of 2020 and 39% for 2021.
The limited price upside shows that the market has already priced in the prospects of sharp earnings growth in the year ahead. Consequently, I’m adopting a neutral rating on OZK.
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.