First Merchants Acquisition May Optimize Funding Costs, But Credit Concerns Will Impact Earnings

Key Takeaways

• Acquisitions and strategic initiatives aim to optimize costs, improve credit quality, and enhance profit margins, boosting revenue and earnings.
  
• Strategic M&A readiness positions the company for potential long-term growth with strengthened financial stability.
  
• Limited loan growth, credit quality concerns, rising interest expenses, and increased non-interest expenses could pressure net margins and impact Old Second Bancorp's profitability.

Catalysts

Operates as the bank holding company for Old Second National Bank that provides community banking services.

• The recent acquisition of First Merchants allows Old Second Bancorp to optimize funding costs, potentially enhancing net interest margins and stabilizing net interest income.
  
• The closure and expected sale of distressed OREO properties early in 2025 could improve the company's profitability and net margins by reducing non-performing assets.
  
• Strategic focus on building commercial loan origination and improved pricing conditions in 2025 aim to drive mid-single-digit loan growth, positively impacting revenue and earnings.
  
• The significant reduction in substandard and criticized loans in late 2024 indicates improved credit quality, which may lower future credit-related expenses and enhance net margins.
  
• With substantial capital build-up and profitability, the company remains well-positioned for strategic M&A, which could drive long-term revenue and earnings growth.

Old Second Bancorp Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Old Second Bancorp's revenue will decrease by -5.6% annually over the next 3 years.
• Analysts assume that profit margins will increase from 31.3% today to 36.1% in 3 years time.
• Analysts expect earnings to reach $83.0 million (and earnings per share of $1.82) by about January 2028, down from $85.3 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 14.0x on those 2028 earnings, up from 9.9x today. This future PE is greater than the current PE for the US Banks industry at 12.3x.
• Analysts expect the number of shares outstanding to grow by 0.62% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 5.92%, as per the Simply Wall St company report.

Old Second Bancorp Future Earnings Per Share Growth

Risks

• The provision for credit losses of $3.5 million and significant loan paydowns indicate limited loan growth, impacting future revenue potential and earnings growth.
  
• The $8.6 million charge-off on a C&I loan and potential additional losses suggest ongoing credit quality concerns, negatively affecting net margins and financial stability.
  
• Rising interest expenses due to market pricing adjustments on commercial deposits and pressure in deposit markets may compress net interest margins, impacting profitability.
  
• Seasonal deposit flows and aggressive deposit pricing by competitors could pose challenges in maintaining net interest income stability.
  
• With expense increases tied to acquisition-related costs and high incentive accruals, the risk of rising non-interest expenses could pressure net margins and overall earnings.

Valuation

• The analysts have a consensus price target of $21.67 for Old Second Bancorp based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $24.0, and the most bearish reporting a price target of just $19.0.
  
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be $229.6 million, earnings will come to $83.0 million, and it would be trading on a PE ratio of 14.0x, assuming you use a discount rate of 5.9%.
  
• Given the current share price of $18.76, the analyst's price target of $21.67 is 13.4% higher. Despite analysts expecting the underlying buisness to decline, they seem to believe it's more valuable than what the market thinks.
  
• 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.