Horizon Bancorp: Earnings Outlook Is Positive, But Credit Risks Remain (NASDAQ:HBNC)

Earnings of Horizon Bancorp, Inc. (NASDAQ: HBNC) increased in the second quarter to $0.33 per share, from $0.26 per share in the first quarter of 2020. The earnings increase was attributable to loan growth under the Paycheck Protection Program and lower provision expense. Earnings will likely continue to increase in the year ahead because of accelerated booking of fees under the Paycheck Protection Program. Moreover, the provision expense will likely continue to decline due to stability in the economic outlook. Consequently, I’m expecting the earnings in the second half of the year to increase by 34% compared to the first half. For the full year, I’m expecting HBNC to report earnings of $1.38 per share, down 10% from last year.

The June 2021 target price suggests a high upside from the current market price. Nevertheless, I’m adopting a Neutral rating on HBNC because of the company’s elevated risk level. Industries sensitive to the COVID-19 pandemic make up 19% of total loans, which pose credit risks. Moreover, HBNC allowed payment modifications on around 13.4% of total loans, which add to the risks.

Provision Expense Likely to Trend Down but Risks Remain High

HBNC’s provision expense declined to $7 million in the second quarter from $8.6 million in the first quarter of 2020. Company management used various economic indexes to determine the provisioning requirement for the quarter, as mentioned in the second quarter’s 10-Q filing. The provision expense will likely continue to decline because the economic outlook has remained stable so far in the third quarter. Further, I’m expecting the economic outlook to continue to remain mostly stable in the year ahead. Therefore, I’m expecting the provision expense to continue to decline in the remainder of the year. For the full year, I’m expecting HBNC to report a provision expense of $22.7 million, up from $2 million in 2019.

The company is currently facing a high level of credit risk because of exposure to COVID-19-sensitive industries, including healthcare, retail, and hotels. The vulnerable industries made up 19% of total loans at the end of the last quarter, as mentioned in the second quarter’s investor presentation. Further, HBNC modified $533.9 million of loans, representing 13.4% of total loans, as mentioned in the 10-Q filing. Management mentioned in the second quarter’s conference call that they expect most of the modified loans to commence regular payments in the third quarter. However, I believe that some industries, especially hotels, will need a second round of payment deferrals. The elevated credit risks can lead to negative surprises in the provision expense in the future.

Accelerated Booking of PPP Fees to be the Chief Driver of Net Interest Income

Net interest income will likely surge in the fourth quarter due to the Paycheck Protection Program, or PPP. HBNC funded $308.1 million of loans under PPP in the second quarter, as mentioned in the 10-Q filing. The company earned total fees of $11.1 million on the PPP loans, which it will recognize over the life of the loans, as mentioned in the presentation. I believe most of the loans will get forgiven in the fourth quarter; hence, I’m expecting HBNC to accelerate the booking of fees in the year ahead.

Excluding the impact of PPP, HBNC’s net interest margin, or NIM, will likely trend down in the year ahead. Yields will likely face downward pressure because loans will continue to reprice and new loans will be originated at lower rates. On the other hand, management expects continued repricing of Certificates of Deposits, or CDs, and a shift in CD balances to transactional accounts to support the NIM, as mentioned in the conference call. According to details given in the presentation, around $400 million of CDs will mature in 2020. Moreover, the CD portfolio has a duration of just over 10 months; hence, I’m expecting deposit costs to continue to decline through the first half of 2021. Overall, I’m expecting NIM to decline by 5bps in the third quarter, 2bps in the fourth quarter, and 9bps in 2021. The following table shows my estimates for yields, cost, and NIM, excluding the impact of the accelerated booking of fees under PPP.

Horizon Bancorp Net Interest Margin

The expected PPP forgiveness in the fourth quarter will reduce the total loan balance in the second half of the year. Excluding PPP, loan growth will likely be tepid over the balance of the year due to the economic slowdown. Considering these factors, I’m expecting HBNC to end the year with a loan balance of $3.6 billion, down 7.9% from the end of June 2020 and down 0.2% from the end of last year. The following table shows my estimates for loans and other balance sheet items.

Horizon Bancorp Balance Sheet Forecast

Expecting Full-Year Earnings of $1.38 per Share

The expected decrease in provision expense and the accelerated booking of fees under PPP will likely increase earnings in the year ahead. Consequently, I’m expecting earnings in the second half of the year to be 34% higher than the earnings in the first half. For the full year, I’m expecting HBNC to report earnings of $1.38 per share, down 10% from last year. The following table shows my income statement estimates.

Horizon Bancorp Income Forecast

Credit Risks Likely to Restrain the Stock Price Despite the Attractive Valuation

I’m using HBNC’s historical average price-to-tangible book ratio (P/TB) to value the stock. The company has traded at an average P/TB multiple of 1.19 in the first half of 2020. Multiplying the average P/TB ratio with the June 2021 forecast tangible book value per share of $11.7 gives a target price of $13.9 for the mid of next year. This price target implies a 28% upside from HBNC’s August 21 closing price, as shown in the table below. The table also displays the sensitivity of the target price to the P/TB ratio.

Horizon Bancorp Valuation Sensitivity

Apart from the upside, HBNC is also offering a modest dividend yield of 4.4%, assuming the company maintains its quarterly dividend at the current level of $0.12 per share. The dividend appears secure because the earnings and dividend estimates imply a payout ratio of only 29% for the fourth quarter and 38% for 2021.

The uncertainties related to the pandemic pose risks to earnings and valuation. The risks are magnified by HBNC’s high exposure to COVID-19-sensitive industries. Moreover, the large portion of loans requiring payment modifications adds to the company’s credit risks. In my opinion, the risks will likely keep the stock price subdued in the near term of two to three months, regardless of the attractive valuation. Hence, I’m adopting a Neutral rating on HBNC.

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.

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