Heritage Commerce Stock: Strong Topline Growth to Boost Profits (NASDAQ:HTBK)

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Heritage Commerce Corp Profit (NASDAQ: HTBK) will rise this year in part due to loan growth driven by economic factors. Additionally, the margin’s moderately high sensitivity to changes in interest rates will boost earnings in a rising interest rate environment. Overall, I expect Heritage Commerce to report earnings of $0.83 per share in 2022, up 5% year-over-year. I have raised my revenue estimate slightly as recent loan growth has exceeded my expectations. Also, I now have a better perspective on net interest margin than before. The current market price is quite close to the target price for the coming year. As a result, I now downgrade Heritage Commerce to Hold odds.

Recovery in the California economy to support loan growth

Heritage Commerce’s actual earnings for 2021 were slightly above my expectations (given in my latest corporate report) due to higher than expected loan growth. Loans jumped 9.1% in the last quarter of 2021, partly due to the purchase of residential mortgages, as mentioned in the earnings release. Organic loan growth was also positive and broad-based during the quarter.

Going forward, the loan portfolio will likely continue to grow due to the economic recovery. Heritage Commerce is based in California, specifically in the San Francisco Bay Area. When measured by the unemployment rate, the state’s economy lags behind the rest of the country. Nevertheless, the unemployment rate has improved considerably since the start of the pandemic, as seen below.

Unemployment rate in the United States compared to San Francisco and California
Data by YCharts

Additionally, the state’s GDP growth in the third quarter of 2021 was above the national average. According to official sources, California’s GDP growth was recorded at 2.9%, while the country’s GDP growth was recorded at 2.3%.

On the other hand, the cancellation of the remaining Paycheck Protection Program (“PPP”) portfolio will limit loan growth. Heritage almost halved its PPP portfolio during the fourth quarter of 2021, but a significant PPP balance is still outstanding on the company’s books. Outstanding PPP loans were $88.7 million at end-December 2021, or 3% of total loans, as mentioned in the earnings release.

Excluding earned growth, Heritage Commerce’s loan growth has hovered in the mid to high single digit range historically. I expect a similar performance in 2022 as the economy is on its way to its pre-pandemic level. As a result, I expect the loan portfolio to grow by 5% in 2022. I also expect deposits and other balance sheet items to grow at the same rate as loans. The following table shows my balance sheet estimates.

EX17 EX18 FY19 FY20 FY21 FY22E
Financial situation
Net loans 1,563 1,859 2,511 2,575 3,044 3,199
Net loan growth 5.4% 18.9% 35.1% 2.6% 18.2% 5.1%
Other productive assets 1,078 973 1,180 1,635 2,054 2,158
Deposits 2,483 2,638 3,415 3,914 4,759 5,002
Loans and sub-debts 39 39 40 40 40 42
Common equity 271 367 577 578 598 617
Book value per share ($) 7.0 8.7 12.0 9.6 9.9 10.2
Tangible BVPS ($) 5.7 6.4 8.1 6.5 6.9 7.2

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

Higher rates to increase the margin

Although the proportion of non-interest bearing deposits to total deposits declined last year, it remains significantly high. Non-interest bearing deposits represented 40.0% of total deposits at the end of December 2021, compared to 42.45% at the end of December 2020. The large proportion of non-interest bearing deposits in total deposits is likely to maintain the average rising cost of deposits in a rising interest rate environment.

Management’s interest rate sensitivity analysis presented in the third quarter 10-Q filing shows that an instantaneous 100 basis point increase in rates can increase net interest income by 13.3% over twelve months. It is important to note that this analysis incorporates the assumption of instantaneous rate variations. A gradual change in rates will most likely have a much smaller effect on net interest income.

A large accumulation of cash and cash equivalents put pressure on the margin last year. Although the company deployed some of its excess cash during the fourth quarter of 2021, the cash balance was still well above normal at the end of the year. If Wealth can still shift its asset mix towards higher yielding assets, then its margin can improve significantly. Even if the company fails to deploy excess cash, the recent upward shift in the middle part of the yield curve will help the company’s average return on earning assets.

Treasury yield curve

US Treasury Department

Given these factors, I expect the net interest margin to increase by four basis points this year, compared to 2.84% in the last quarter of 2021. Previously, I expected the margin remains stable in 2022, as mentioned in my last report.

Allocation to provisions likely to remain moderate

Heritage Commerce has released a large portion of its loan loss reserves through 2021. Further reserve releases cannot be ruled out as the existing level of provision is quite high relative to the credit risk of the portfolio. As mentioned in the earnings release, provisions represented 1.4% of total loans, while non-performing loans represented only 0.12% of total loans at the end of December 2021. This year’s reversals will be most likely lower than last year. because there is less room for reserve releases now.

Strong expected loan growth will increase the provision charge for this year. Overall, I expect the provision charge, net of reversals, to be higher than last year, but still lower than normal. I expect provision charges to be around 0.09% of total loans in 2022. By comparison, provision charges were 0.13% of average loans from 2016 to 2019.

Revenue is expected to grow 5% year-over-year

Expected loan growth and expanding margins will likely boost earnings this year. On the other hand, a higher net provision charge will limit earnings growth. Overall, I expect the company to report earnings of $0.83 per share in 2022, up 5% year-over-year. The following table shows my income statement estimates.

EX17 EX18 FY19 FY20 FY21 FY22E
income statement
Net interest income 102 122 132 142 146 159
Allowance for loan losses 0 seven 1 13 (3) 3
Non-interest income ten ten ten ten ten 11
Non-interest charges 61 76 85 90 93 97
Net income – Common Sh. 24 35 40 35 48 50
BPA – Diluted ($) 0.62 0.84 0.84 0.59 0.79 0.83

Source: SEC filings, earnings releases, author’s estimates

(In millions of dollars, unless otherwise indicated)

I have increased my earnings estimate for 2022 from an estimate of $0.72 per share given in my last report on the company. This upward revision is partly attributable to the surprising loan growth in the fourth quarter of 2021, which pushed up my average loan balance for 2022. In addition, I now have a better outlook on the net margin of interest than before.

Actual earnings may differ materially from estimates due to risks and uncertainties related to the COVID-19 pandemic, particularly the Omicron variant.

Downgrade pending

Heritage Commerce offers a dividend yield of 4.2% at the current quarterly dividend rate of $0.13 per share. Earnings and dividend estimates suggest a payout ratio of 63% for 2022. Although this payout ratio is quite high, I am not worried about a reduction in the dividend as the company has maintained a higher payout ratio 50% in each of the last seven years. .

I use historical price-to-earnings (“P/TB”) and price-to-earnings (“P/E”) multiples to value Heritage Commerce. The stock has traded at an average P/TB ratio of 1.72 in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
T. Book value per share ($) 6.4 8.1 6.5 6.9
Average market price ($) 15.7 12.3 8.3 11.2
Historical P/TB 2.44x 1.52x 1.28x 1.63x 1.72x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/TB multiple by the expected tangible book value per share of $7.2 yields a target price of $12.3 for the end of 2022. This price target implies a decline of 1.3% compared to the closing price on January 28. The following table shows the sensitivity of the target price to the P/TB ratio.

Multiple P/TB 1.52x 1.62x 1.72x 1.82x 1.92x
TBVPS – Dec 2022 ($) 7.2 7.2 7.2 7.2 7.2
Target price ($) 10.9 11.6 12.3 13.0 13.8
Market price ($) 12.5 12.5 12.5 12.5 12.5
Up/(down) (12.8)% (7.1)% (1.3)% 4.4% 10.1%
Source: Author’s estimates

The stock has traded at an average P/E ratio of around 15.5x in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
Earnings per share ($) 0.84 0.84 0.59 0.79
Average market price ($) 15.7 12.3 8.3 11.2
Historical PER 18.8x 14.6x 14.2x 14.2x 15.5x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/E multiple by the expected earnings per share of $0.83 yields a price target of $12.8 for the end of 2022. This price target implies a 2.5% upside from at the January 28 closing price. The following table shows the sensitivity of the target price to the P/E ratio.

Multiple P/E 13.5x 14.5x 15.5x 16.5x 17.5x
EPS – 2022 ($) 0.83 0.83 0.83 0.83 0.83
Target price ($) 11.1 12.0 12.8 13.6 14.5
Market price ($) 12.5 12.5 12.5 12.5 12.5
Up/(down) (10.8)% (4.1)% 2.5% 9.1% 15.7%
Source: Author’s estimates

An equal weighting of the target prices from the two valuation methods gives a target price of $12.6, which implies an increase of 0.6% compared to the current market price. Adding the forward dividend yield gives an expected total return of 4.7%.

In my latest report on Heritage Commerce, which was released after the second quarter results, I took a bullish note on the company. Since the publication of this report, the share price has rallied to a point quite close to the target price. Therefore, I now downgrade Heritage Commerce to Hold odds.

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