Rising Costs And Slowing Loan Growth Threaten Bank Earnings Stability

Key Takeaways

• Elevated loan-to-deposit ratio and declining net interest margins indicate potential liquidity strain and reduced profitability.
  
• Strategic shift to balance deposits and loans may compress net interest margins, impacting earnings despite higher asset yields.
  
• Strong local deposit and loan growth, combined with diversified income streams and robust risk management, positions Mercantile Bank for stable and improved future earnings.

Catalysts

Operates as the bank holding company for Mercantile Bank of Michigan that provides commercial and retail banking services to small- to medium-sized businesses and individuals in the United States.

• The elevated loan-to-deposit ratio, which reached 110% at year-end 2023, indicates potential strain on liquidity as loan growth outpaces deposit growth. This may impact future revenue as the bank focuses on reducing this ratio, potentially curtailing loan growth.
  
• Expected deceleration in commercial loan growth could negatively impact revenue growth. The current pipeline reflects corporate customers reducing loan balances due to excess cash flow and asset sales.
  
• The decline in net interest margin, which fell 46 basis points in Q3 2024 compared to Q3 2023, signifies squeezed profitability. This is attributed to higher funding costs outpacing the increase in asset yields, compressing net margins.
  
• The strategic initiative to lower the loan-to-deposit ratio by increasing costly deposit growth over loan growth is likely to further compress the net interest margin, thereby affecting earnings.
  
• With a significant portion of deposits moving to higher-cost products, increased interest expense on deposits erodes net interest income, challenging earnings growth despite growing asset yield potential.

Mercantile Bank Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Mercantile Bank's revenue will grow by 4.4% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 36.0% today to 28.5% in 3 years time.
• Analysts expect earnings to reach $72.0 million (and earnings per share of $4.39) by about October 2027, down from $80.0 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $80 million.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 13.2x on those 2027 earnings, up from 9.2x today. This future PE is greater than the current PE for the US Banks industry at 12.0x.
• Analysts expect the number of shares outstanding to grow by 0.54% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 6.59%, as per the Simply Wall St company report.

Mercantile Bank Future Earnings Per Share Growth

Risks

• Mercantile Bank's significant reduction in the loan-to-deposit ratio, accompanied by strong local deposit growth, provides a solid foundation for improved net interest margins over time, potentially increasing net earnings.
  
• Strong local loan growth, past solid commercial and mortgage lending, supports future revenue streams and earnings, especially as interest income on loans remains high in the current environment.
  
• Steady growth in noninterest income, with a 27% increase within the first three quarters of 2024, suggests diversified revenue streams beyond traditional lending that could support earnings even in varying economic climates.
  
• The bank's focus on excellent asset quality with low nonperforming assets and vigorous risk management measures could maintain profitability and safeguard net margins against economic downturns.
  
• Net interest income benefits from strategic allocation and improved loan yields amidst rate changes, indicating potential resilience against margin pressures, thus supporting ongoing earnings stability.

Valuation

• The analysts have a consensus price target of $48.88 for Mercantile Bank based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $252.7 million, earnings will come to $72.0 million, and it would be trading on a PE ratio of 13.2x, assuming you use a discount rate of 6.6%.
  
• Given the current share price of $45.4, the analyst's price target of $48.88 is 7.1% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.