Arrow Financial Stock: Decent loan growth to partially counter higher borrowing costs (AROW)

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Earnings of Arrow Financial Corporation (NASDAQ: AROW) will enjoy decent loan growth this year. On the other hand, accelerating loan growth will result in a higher net provision charge this year than last year, which will weigh on earnings. Meanwhile, the network the interest margin is likely to remain stable this year as the benefits of rate hikes will be felt with some lag. Overall, I expect Arrow Financial to report earnings of $3.00 per share in 2022, down 3% year over year. Compared to my last report on Arrow Financial, I have slightly lowered my earnings estimate. The year-end target price suggests a moderately high upside from the current market price. Therefore, I maintain a buy rating on Arrow Financial Corporation.

Loan growth should remain strong

Arrow’s loan portfolio grew by an impressive 2.6% in the first quarter of 2022, or 10.4% annualized, which exceeded my expectations. As mentioned in the Q1 earnings release, the growth was driven primarily by auto loans and residential real estate loans. Although the impressive first quarter growth is unlikely to be repeated, loan growth is expected to remain strong in the coming year.

Arrow Financial operates in New York and focuses primarily on consumer and residential real estate lending, which accounted for 70% of total lending last quarter. Therefore, I think the New York State unemployment rate is a good indicator of future product demand. Although the state’s unemployment rate is lower than national average, he has still recovered considerably from the pandemic. As shown below, the unemployment rate is now back to the level seen at the end of 2018.

Chart
Data by Y-Charts

Primarily due to low unemployment and therefore the apparent financial strength of consumers, I believe loan growth can remain strong for the remainder of the year. Overall, I expect the loan portfolio to grow by 7% by the end of 2022 compared to the end of 2021. Meanwhile, other balance sheet items will likely grow more or less in line with loans. The following table shows my balance sheet estimates.

EX17 EX18 FY19 FY20 FY21 FY22E
Financial situation
Net loans 1,932 2,176 2,365 2,566 2,641 2,833
Net loan growth 11.3% 12.6% 8.7% 8.5% 2.9% 7.3%
Other productive assets 676 646 638 930 1,194 1,253
Deposits 2,245 2,346 2,616 3,235 3,550 3,885
Loans and sub-debts 245 354 231 88 70 49
Common Equity 250 270 302 334 371 380
Book value per share ($) 16.8 18.1 20.1 21.6 23.1 23.6
Tangible BVPS ($) 15.2 16.5 18.6 20.1 21.6 22.2

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

The margin is inversely related to short-term interest rates

The topline’s immediate response to a rise in interest rates is negative due to the mismatch between revaluation of assets and liabilities. Liabilities are quickly reassessed as the deposit book is heavy with interest-bearing checking and savings accounts. These fast-repricing deposits accounted for 73% of total deposits at the end of March 2022. On the other hand, assets are slower to reprice due to the high concentration of residential mortgages, which constitute the largest category. loans for Arrow. Financial. According to details given in the latest 10-Q filing, residential real estate loans accounted for 36% of total loans during the first quarter of 2022.

Management’s interest rate sensitivity analysis in File 10-Q shows that a 200 basis point increase in interest rates can reduce net interest income by 0.89% in the first year of rising rates. In the second year, net interest income can increase by 5.79%.

Arrow Sensitivity to financial rates

Filing 1Q2022 10-Q

Given these factors, I expect the margin to remain essentially stable in the remaining nine months of 2022, compared to 2.90% in the first quarter of the year.

The provision charge should normalize this year

After remaining subdued in 2021, net loan loss provisions returned to a more normal level in the first quarter of 2022. As loan growth is likely to be higher this year compared to last year (see below). above), the provision for expected loan losses will also be higher.

Unlike last year when provision releases were at a high level, I expect provision releases to normalize this year due to the level of reserves relative to the credit risk of the portfolio. The ratio of provisions to total non-performing loans fell to 280.0% at the end of March 2022, from 318.3% at the end of March 2021.

Overall, I expect provisions, net of reversals, to return to normal levels this year. I expect Arrow Financial to report a net provision charge of 0.12% of total loans in 2022, which is the same as the average from 2017 to 2019.

Expect earnings to drop 3%

A higher net provision charge will likely weigh on earnings this year compared to last year. On the other hand, the anticipated loan growth will limit the decline in earnings. Overall, I expect Arrow Financial to report earnings of $3.00 per share in 2022, down 3% year over year. The following table shows my income statement estimates.

EX17 EX18 FY19 FY20 FY21 FY22E
income statement
Net interest income 78 84 88 99 110 114
Allowance for loan losses 3 3 2 9 0 3
Non-interest income 28 29 29 33 32 32
Non-interest charges 63 65 67 71 78 81
Net income – Common Sh. 29 36 37 41 50 48
BPA – Diluted ($) 1.98 2.43 2.50 2.64 3.10 3.00

Source: SEC Filings, Author’s Estimates

(In millions of dollars, unless otherwise indicated)

In my last report on Arrow Financial, I estimated earnings of $3.07 per share. I reduced my earnings estimate slightly as I changed my margin estimate lower in light of recent inflation reports and Fed projections. (Please keep in mind that the margin is inversely proportional to short-term interest rates.)

Actual earnings may differ materially from estimates due to the risks and uncertainties associated with inflation and, therefore, the timing and magnitude of interest rate increases.

High Price Rise Warrants Buy Rating

Arrow Financial offers a dividend yield of 3.2% at the current quarterly dividend rate of $0.27 per share. Earnings and dividend estimates suggest a payout ratio of 36% for 2022, which is below the five-year average of 41%. Therefore, the dividend looks secure.

I use historical price/book tangible (“P/TB”) and price/earnings (“P/E”) multiples to value Arrow Financial. The stock has traded at an average P/TB ratio of 1.73 in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
T. Book value per share ($) 16.5 18.6 20.1 21.6
Average market price ($) 34.0 33.3 29.3 34.9
Historical P/TB 2.06x 1.79x 1.46x 1.61x 1.73x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/TB multiple by the expected tangible book value per share of $22.2 yields a target price of $38.4 for the end of 2022. This price target implies an upside of 15.3% compared to the closing price on June 2. The following table shows the sensitivity of the target price to the P/TB ratio.

Multiple P/TB 1.53x 1.63x 1.73x 1.83x 1.93x
TBVPS – Dec 2022 ($) 22.2 22.2 22.2 22.2 22.2
Target price ($) 33.9 36.2 38.4 40.6 42.8
Market price ($) 33.3 33.3 33.3 33.3 33.3
Up/(down) 1.9% 8.6% 15.3% 21.9% 28.6%
Source: Author’s estimates

The stock has traded at an average P/E ratio of around 12.4x in the past, as shown below.

EX18 FY19 FY20 FY21 Medium
Earnings per share ($) 2.43 2.50 2.64 3.10
Average market price ($) 34.0 33.3 29.3 34.9
Historical PER 14.0x 13.3x 11.1x 11.3x 12.4x
Source: Company Financials, Yahoo Finance, Author’s Estimates

Multiplying the average P/E multiple by the expected earnings per share of $3.00 yields a price target of $37.3 for the end of 2022. This price target implies an upside of 11.9% over at the closing price on June 2. The following table shows the sensitivity of the target price to the P/E ratio.

Multiple P/E 10.4x 11.4x 12.4x 13.4x 14.4x
EPS 2022 ($) 3.00 3.00 3.00 3.00 3.00
Target price ($) 31.3 34.3 37.3 40.3 43.3
Market price ($) 33.3 33.3 33.3 33.3 33.3
Up/(down) (6.1)% 2.9% 11.9% 21.0% 30.0%
Source: Author’s estimates

Equal weighting of target prices from both valuation methods gives a combined result target price of $37.8, implying a 13.6% upside from the current market price. Adding the forward dividend yield gives an expected total return of 16.8%. Therefore, I maintain a buy rating on Arrow Financial.

About Barbara J. Ross

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